Spwarnsonincreasingbankingsystemvulnerabilitiesandlabelsaustraliaa One-Trickpony

DownUnderWrapforweekendingNovember23, 2012

SPwarnsonincreasingbankingsystemvulnerabilities

Miningpeakmovesintofocus

ImmediateeconomicoutlookimprovesinChina, buttroublespersist

SPwarnsonincreasingbankingsystemvulnerabilitiesandlabelsAustraliaa“one-trickpony”foritsover-relianceonmining:

Lastweek, StandardPoors (SP) issuedawarningthattheAustralianeconomycouldfaceaSpanish-stylebustifexternalconditionsweretodeterioratematerially:

“Australia’salready, asweseeit, gotsomecreditmetricsthatarerightoffthescalewhenitcomestoassessingAustralia’sexternalposition…It’sgothighlevelsofexternalliabilities, it’sgotveryweakexternalliquidityandthatbasicallymeansthebanksareveryhighlyindebtedcomparedtotheirpeers…Forus, welooktoSpain, whichwasAustralia’sclosestpeerfourorfiveyearsagointermsofhavingaverystrongfiscalposition, verysimilartowhatAustraliahasatthemoment, itsexternalpositionwasweaker, likeAustralia’s, anditgotroutedveryquickly…Thegovernmentneededtoprovidesupporttothebanks, ithadtoshoreupgrowthintheeconomyanditsdebtlevelsmorethandoubled…WecanseethathappeninginAustralia’scase.”

ThisweekSPsharpeneditscriticism, thistimewarningthatthebanksfacealiquiditycrisisintheeventthatforeignsentimentfades, andlabellingtheAustralianeconomya“onetrickpony”foritsover-dependenceontheminingsectortodriveemployment, incomesandgrowth:

“Thebanksarehighlyindebted, they’rehighlyleveraged, theyarethemainvehicleAustraliausestofunditscurrentaccountdeficit…Australiahas, asweseeit, gotsomecreditmetricsthatarerightoffthescalewhenitcomestoassessingAustralia’sexternalposition…It’sgothighlevelsofliabilities, it’sgotveryweakexternalliquidityandthatbasicallymeansthebanksarehighlyindebtedcomparedtotheirpeers…They’rebenefitingfromasafehavenatthemoment–nonethelessinvestorsentimentcanturnveryquickly…Wejustworrythatatsomepoint, thepeoplewhoarefundingtheAustralianbanksmaydecidethatenoughisenoughandmaybegintoloseconfidenceinthebank’sabilitytorollovertheirdebt…ThatwouldcomethroughaweakeninginAustralia’smajortradingpartnersflowingthroughtoadramaticweakeninginAustralia’sfiscalposition…AnythingthatweighsontheabilityofAustraliatobringforwardnewenergyprojectsandthatweighsonitsexportgrowthpotential, that’ssomethingthatwouldputpressureontherating. Australiaislookingincreasinglylikeaone-trickpony.”

TheAustralianbankingsystem’sheavyrelianceonexternalfunding, aswellastheAustralianeconomy’sover-relianceontheminingindustry, havebeenmajorthemessinceourinauguralreportinNovember2011.

Thebankingsystem’sheavyuseofoffshoreborrowings (mostlybondissuance) enabledthebankstoexpandtheirassets (loans) atarapidrate,andwasoneofthekeydriversoftheAustralianhousingbubble.

Bankoffshoreborrowingsgrewfromonly $27billionin1988toapeakof $675billioninSeptember2011, beforefallingto $615billioncurrently.

Asapercentageoftotalbankloans [liabilities], bankoffshoreborrowingsrosefrom21% [12%] in1988toapeakof45% [28%] inDecember2009, beforesettlingat36% [24%] currently (seenextchart).

WhencomparedtoGDP, Australianbankoffshoreborrowingsrosefromonly8% ofGDPin1988toapeakof51% ofGDPinDecember2009, beforesettlingbackat42% ofGDPcurrently. Overthesameperiod, totalbankassetsgrewfrom70% ofGDPin1988toapeakof207% ofGDPinJune2009, beforefallingbackto195% ofGDPcurrently.

Thenextchart, whichmapsthegrowthofthesecomponents, suggeststhatAustralia’sbankswouldneverhaveexperiencedanywherenearthedegreeofasset (loan) growthwithoutthisaccesstooffshorefundingmarkets.

Thisloangrowthhasbeenfunnelledintothehousingmarket, asillustratedbythenextchart, whichshowstheproportionofbankloanscomprisedofmortgagesgrowingfrom24% in1990to59% currently:

Oneconsequenceofthebanks’offshorefundingbinge, andstronggrowthinassets, isthatthebank-dominatedfinanceandinsurancesectorhasmorethandoubledinsizerelativetotheoverallAustralianeconomy (seebelowcharts).

MuchofthisgrowthinbankassetsandmortgagelendinghasbeencapitalizedintoAustralianhouseprices, whichdecoupledfromrentalgrowthinthelate-1980sfollowingthederegulationoftheAustralianfinancialsector. NotethestrongsimilaritiesbetweenthechartdirectlyaboveshowingfinancialsectorgrowthandtheonebelowshowingthegrowthinAustralianhouseprices.

TheinherentvulnerabilityoftheAustralianbankingsystemwasalsoacknowledgedlatelastweekinthereleaseoftheInternationalMonetaryFund’s (IMF) FinancialSystemStabilityAssessment (FSAP) onAustralia. ThisdocumentcontainedtwokeychartshighlightingtheprecariouspositionofAustralia’sbanks, namely:

1)AnextremeconcentrationofAssets, withAustralia’sbigfourbanksholdingthehighestpercentageofbankingassetsinthedevelopedworldfollowedbyNewZealand, whosebigfourbanksareownedbyAustralia’sbigfour. Thesebigfourbanksalsohold88% ofresidentialmortgagesinAustralia. And, accordingtotheIMF, theyareamongeachother’slargestcounterparties, meaning“theirexpecteddefaultfrequenciesarehighlycorrelated”suchthatifoneofthemfailedthen“theimpactonthefinancialsystemandtheeconomywouldbepotentiallysubstantial”:

2)Thehighestshareofnetexternalliabilitiesinthedevelopedworld:

Reflectingtheseconcerns, theIMFhasrecommendedaraftoffundamentalpolicychangesaimedatimprovingfinancialsystemstability. Inparticular, theIMFadvocatesthattheAustralianPrudentialRegulationAuthority (APRA) requirethebigfourtoholdadditionalTier1capital (orequity) toprovidebetter“lossabsorbency”.TheIMFhasalsorecommendedthatAPRAandtheReserveBankofAustralia (RBA) developgreaterstress-testingcapabilities. ItclaimsthatAPRAdelegatestoomuchstresstestingtobanks, whichthenbecomehardtodecipher, andnotesthattheRBAdoesnotdoanystresstestingitself, eventhoughitclaimsresponsibilityforsystemstability.

WhiletheJointIMF/APRAstresstestingofAustralia’sbankssuggeststhattheywouldsurviveaseveredownturn (i.e. a -5% declineinGDP, a -50% dropincommodityprices, a -35% fallinhouseprices, andanincreaseintheunemploymentrateto12%), therearealotofunansweredquestions.

Inparticular, thestresstestdoesnotconsidertheprospectoffailurebylendersmortgageinsurers, GenworthandQBELMI. TheseLMIshavebeenshowntooperatewithverythincapitalbuffers (lessthat1%), yettheyprovideinsurancefortheriskiest50% ofAustralia’sresidentialmortgages (about $600billion). IftheLMI’swereunabletosurvivesuchashock, thenAustralia'sbankswouldbeleftshortofclaimsandwouldneedtoabsorbthoselossestoo. Moreover, undertheBaselcapitalregime, Australia’sbankssignificantlyreducetheirriskweightingsbecauseofthismortgageinsurance. WeretheLMIstofail, thenbyextensionoverallmortgagerisk-weightingswouldincreaserequiringthebankstofindmorecapital.

Second, thewayinwhichtheassumed -35% fallinhousepricesandtheincreaseintheunemploymentrateto12.5% feedsthroughtocreditlossesinthestresstestisunrealistic. TheIMF/APRAusesthereductioninhousepricestoestimatelossgivendefault (LGD), whereasunemploymentisusedasastressforprobabilityofdefault (PD). Forexample, defaultsareassumedtoincreaseby70% oftheincreaseofunemployment (12.5% minus5.5% = 7%), whichequals4.9%. Theincreaseddefaultlevelof4.9% multipliedbythe $1,100billionofresidentialmortgagesonthebanks’booksgivesaPDnumberof $54billion. WhenmultipliedbytheLGDof35%, thetotalpredictedbanklossesundertheIMF/APRAstresstestisaround $19bnor1.7% oftotalbankresidentialmortgageloans.

WhilstAustralia’sbankswouldhavesomedifficultywithlossesofthissize, ifthat’salltherewas, thenitwouldbemanageable. Butweknowfrominternationalexperience, suchastheUSintheGlobalFinancialCrisis (GFC), thattheassumptionthanonlytheunemployedwoulddefaultontheirmortgagesismisplaced, andactuallossesresultingfroma -35% across-the-boardfallinhousepriceswouldlikelybemuchhigher.

Thenthereistheissueofthebanksneedingtomaintaintheircreditratingsaswellastheirabilitytofundbothdomesticallyandoffshore. Havingwiped-outtheirlossprovisionsofaround $20billion, theywouldberequiredtonotonlyreplenishthoseprovisionsbackto $20billionbuttoalsoincreaseprovisionstocovertheincreaseinexpectedfuturelosses.

Finally, duringthefalloutofanextremecreditevent, thebankswouldberequiredtorevisittheirinternalrisk-basedcalculationsforresidentialmortgageriskweightingsandcapital. Onaverage, Australia’sbigfourbanksholdonly1.6% ofcapitalagainsttheirresidentialmortgageexposures (seebelowchart), whichequatestoaround $21billionofcapitalonly.

Finally, itislikelythatthebanks’owninternalmodelswouldrequireasignificantincreaseinrisk-weightedassets, especiallygiventhatintheextremestressscenariotheLMIsarelikelytobeimpaired. Forexample, wererisk-weightedassetsonmortgagestodoubleto, say, 3.2% (implyinganaverageBasel2risk-weightingof40%, whichisstilllow), anextra $21billionofcapitalwouldberequiredtobeheldbyAustralia’sbigfourbanks.

Likemostbankstresstests, theIMF/APRAstudyistoonarrowinscopeandfailstotakeaccountofsecondroundeffects. Ithas, therefore, producedanunrealisticresultthatprovidesfalsecomforttoAustralia’sfinancialregulators. Shouldaseverecrediteventtakeplace, theAustralianbanksarelikelytobefoundtobeswimmingnaked, exposedtobothcripplingcreditlossesinadditiontoaseverecreditsqueezeasoffshorefundingmarketsgetexpensiveatthesametimeasbankdepositgrowthiscrimpedduetotheworseningeconomy. Australiantaxpayerswould, therefore, likelybecalledupontobail-outthebanks, potentiallythroughtheLMIsand/orviamassiveliquiditysupportfromtheRBAtoreplacethelostoffshorefunding.

Evenifanextremecrediteventdoesnottakeplace, Australia’sbanksarelikelytofindfundingproblematic.

Whileoffshoreborrowingsweretheprimarydriveroflendinggrowthinthedecadeto2008, sincetheonsetoftheGFC, depositshaveplayedtheprimaryrole (seebelowcharts).

ThissurgeindepositswasfacilitatedbytheaccumulationofbudgetdeficitsbytheAustralianGovernment, thetradesurplusesin2010and2011 (seebelowcharts), anddecliningratesofcreditgrowth.

Withprivatesectorincomeandsavingslikelytotakeahitasthegovernmentstrivestoreturnthebudgettosurplus, thetradebalanceworsens, andunemploymentrises, depositgrowthintoAustralia’sbanksislikelytocontract. Accordingly, thebankswillberequired, onceagain, toseekfundingexternallyinordertogrowtheirbalancesheets.

However, thecreditratingsagencieshavewarnedonmultipleoccasionsthattheyareuncomfortablewiththebanks’currentlevelofexternalliabilitiesandwoulddowngradetheirratingsshouldtheyincrease. TheAustralianbankingsystem, therefore, isfacingacreditconstrainedfuture, irrespectiveofwhetheranextremecrediteventtakesplace.

PeakAustralia:

SPs“onetrickpony”statementisparticularlyaptgiventheexpectedpeakingofAustralia’smininginvestmentboom, whichhaspoweredgrowthinnationalGDP, incomesandjobs (seenextchart).

Untilrecently, mostanalystsexpectedthatthebulkofuncommittedprojects–thoseshowninredabove–wouldproceed. However, followingtherecentslumpincommodityprices, anumberoflargeprojectshavealreadybeenplacedonholdorcancelledaltogether, withtheminingcompaniessignallingfurthercutstoexpansionplansandjobs.

Asnotedrecently, thecoalandgasindustries–Australia’ssecondandfourthbiggestexports–areunderfirefromtheshalegasboomintheUS. ThishasalreadyseensignificantcoaltogasswitchinginpowerandhasresultedinsurplusUScoalsuppliesbeingdumpedintoAsia, thuscompetingwithAustraliancoalexports.

TheAustraliangasindustry, whichisviewedasagrowthindustrywithinAustralia, isalsounderpressure. First, theJapaneseareseekingtobreaktheoil-benchmarkpricingsystem, whichisplacinglongtermsupplycontractsindoubt, andthreateningdoubledigitgasprices. Tomakemattersworse, requestsforapprovaltoexportliquefiednaturalgas (LNG) fromtheUShavesurged, threateningtodepressgaspricesglobally.

InMarch2012, theBureauofResourceandEnergyEconomics (BREE) releaseditsquarterlyResourceandEnergyOutlook,whichlistedtenUSexportprojectswithacombinedexportcapacityof104mtseekingapprovaltoexporttonon-FTAnations (mostlyAsia). SinceMarch, USexportapprovalrequestshaveswelledto15LNGprojects, althoughitisnotclearhowmuchextracapacitytheseprojectsentail. Australia’scurrentexportcapacityisonly20mtandisexpectedtoexpandto63mtoncethecurrentroundofprojectsunderconstructioniscomplete. Therefore, thereareapplicationstoexportLNGfromtheUSthatareatleastfivetimescurrentAustralianexportcapacityandmorelikelydoubleprojectedcapacity.

TheIEAchartbelowillustratesthepremiumthatisavailabletoUSshalegasproducersfromliquefyingandexportingtheirgastoJapan (whichisaproxyforthepricesinAsiamoregenerally) atcurrentprices. Rightnow, thepureprofitis $US6.10–morethantwicetheentirerevenue (letaloneprofit) theseproducersaregettingfortheirgasdomestically. Althoughmarginsareexpectedtonarrowby2020, gasexportstoAsiaareexpectedtoremainfarmoreattractivethanpricesavailablewithintheUS.

Untilnow, AustralianLNGproducershavehadacosycompetitiveenvironmentforAsiancustomers, facinglittlecompetitionfromabroad. Goingforward, however, competitionisexpectedtoheat-upconsiderablyfromlowercostandequallyreliableUSsupplies.

ThebelowDeutscheBankchartillustratesthecostoftheUSgasliquefactionplantcurrentlyunderwayinred - SabinePass - relativetoarangeofotherLNGprojectsconstructedinthepastandcurrentlyplanned. SabinePassisabouthalfthecapitalcostofAustralianprojectsplannedforGladstone (QCLNG, GLNG, APLNG), andathirdofthecostofseveralWesternAustralianandNorthernTerritoryprojects (Wheatstone, Pluto-1, Gorgon, Sunrise, Prelude).

TherearecurrentlysixpotentialLNGprojectsinAustralia, worthinexcessof $190billion, whicharescheduledtoreachinvestmentdecisionsin2013. WithcompetitionfromtheUSgrowing, inadditiontolargediscoveriesofgasinAfrica, itishighlylikelythatsomeormostoftheseprojectswillendupbeingplacedonhold.

Thenewshasalsoworsenedforironore–Australia’slargestexportcommodity. Thisweek, Chinesestatemediareportedthatthe25% taxratepaidbydomesticironoreproducerswouldbehalvedwithintwo-to-threemonthsinabidtomaintainlocalsupplyanddrivedownthepricesreceivedbyAustralianandBrazilianminers.

ThedecisionbyChina, whichaccountsfornearlytwo-thirdsofseaborneironoretrade (seebelowchart), shattersonceandforallthecommon“pricefloor”assumptionofcommoditiesanalystsandminingexecutivesthatChineseironoreproductionwouldshut-downatpricesbelowUS$120pertonne.

TheincomingChinesepremieralsoannouncedthisweekthatitwouldnolongerpursue“one-sidedGDPgrowth” (i.e. fixedassetinvestment-ledgrowth) andthatdevelopmentwouldbeata“mediumspeed”inthelongterm. ThissuggeststhattheChineseleadershipisseekingtorebalancegrowthtowardsconsumptionandthatanotherbigstimuluspackagewillnotbeforthcoming.

Allinall, thesedevelopmentssuggestthattheworldisfacingaglutinallofthemajorAustralianexportcommodities–ironore, coalandgas–andthattheminingboomthathasunderpinnedtheAustralianeconomyisfastcomingtoanend.

ImmediateeconomicoutlookinChinaimproves:

Whilethemediumtolonger-termoutlookforChinesecommoditydemandhasdeteriorated, duetotheChineseeconomy’splannedshifttowardsconsumption-baseddemand (whichisnecessarilylesscommodity-intensive), theimmediateoutlookhasimproved.

Thisweek, theHSBC/MarkitFlashPerformanceofManufacturing (PMI) surveyregistereditsfirstexpansionin13months,increasingto50.4inNovemberfrom49.5inOctober (seebelowchart).

Asusual, thecomponentstellamorecomplextale. Newexportordersbrokeintopositiveterritory, howeveremploymentisstillcontracting, albeitataslowerrate. Finishedgoodsinventoriescontinuedtodecrease, whereasrawmaterialsandotherintermediateproductsincreased, suggestingoverallmanufacturingproductionwillincreasethroughtotheendoftheyear (seebelowtable).

ThepositivenewsonthePMIhasalsobeenmetrecentlywithincreasesinelectricityconsumptionandrailfreightvolumes, whicharepreferredalternativemeasuresofeconomicactivity (seebelowcharts).

Importantlyforcommoditydemand, Chinesefixedassetinvestmenthasalsoincreasedrecently, drivenbyinfrastructureinvestment (seebelowchart).

Despitethepositivenews, China’sA-share (onshoremarket) non-financialcompaniescontinuetorunataloss, raisingquestionsabouttheoverallrobustnessoftheChineseeconomicrecovery (seebelowchart).

Meanwhile, thefinancialsituationinChinaappearstobeworsening. TheAtlanticreportedthisweekthatsomeChineseprovincesarecollectingtaxesearlythisyearfromChinesebusinessesinanattempttooffsetdecliningrevenuesfromfallinglandsalesandslowereconomicgrowth.

Chinesebanksalsocontinuetoextendloanstotroubledcompaniesatbelowmarketratesinwhatisbecomingauniqueformof‘extendandpretend’. OneoffourfirmschargedwithcleaningupbaddebtsatChina'sbanks, OrientAssetManagementCorp, reportedrecentlythatChina’sbaddebtscouldtripleinsizebytheendoftheyearasloansmadetothesteel, shipbuildingandsolarsectors, inparticular, turnbad.