Welcome to Finance & Fury, the ‘Say What Wednesday’ edition.

Today’s question comes from Brad,

“Any chance you could do a podcast on Australian foreign debt? Is it possible to pay it off? Will paying it off have a negative effect on our economy? Are most or all countries on the path to austerity?”

Brad! Awesome questions as it will flow well into next Friday’s Furious Friday episode. We’ll tackle some of the debt issues here, which actually adds to the structural issues that our economy will face …which might cause some issues in the share market and property market.

But to start off with…What is Foreign Debt?

Foreign Debt is the total of government, financial institution, household and business debt that is borrowed overseas. Australia’s Net Foreign Debt totalled just under $1 trillion last year.

  • It’s important to note that foreign debt does not equal national debt, which is the total government debt. It comprises government borrowings from overseas residents and government borrowings from Australian residents and thus excludes overseas borrowings by the private sector.
  • It doesn’t equal Household Debt (which is massive as well)
  • Foreign debt is distinguished from other forms of foreign investment capital inflow such as foreign ownership as it carries with it the obligation to pay interest and repay the principal.

 

Types of Debt

Gross foreign debt is the sum of all non-equity liabilities by Australian residents, the major component of which is the total amount of borrowings from non-residents by residents of Australia.

  • It includes securities issued such as bonds as well as loans, advances, deposits, debentures and overdrafts.
  • In Australia the figure is close to $2tr which is a dramatic increase since 2005 when it was close to only $500bn

Net foreign debt is equal to gross foreign debt minus lending by residents of Australia to non-residents and non-equity assets such as foreign reserves held by the Reserve Bank.

  • Sitting at about $1tr at the moment
  • Reserve assets held by the Reserve Bank comprises gold, foreign exchange, special drawing rights and Australia’s reserve position in the International Monetary Fund.

 

Where has this come from? It’s all behind the scenes.  

Most of Australia’s $1 trillion dollars in net foreign debt has been borrowed through the banking system and used to increase home lending. This has helped fuel property price increases. As at June 2017, the banking sector had borrowed some $850 billion from offshore, equating to 49% of Australia’s GDP

  • The Irony – Australia’s government debt is relatively low when comparing us to other countries but due to the Federal Budget being hamstrung slightly by the banks and their offshore borrowing excesses. The Government has to limit its own borrowing that it would normally spend on things like infrastructure or other projects.
  • There is a fear that Australia will lose its very safe AAA credit rating. Many of the ratings agency tell a similar story.
    • This would downgrade the banks credit ratings and lead to the unravelling of the private debt bubble created by the banks. This also increases the costs of lending for everyone; the Government, the banks, you and me.

With a lot of our net foreign debt tied up in the financial system (especially in home/property lending) there is going to be a bit of an issue if we lose our AAA rating and the cost of borrowing goes up. Essentially then it will be up to us to pay this debt off rather than the government, especially given the new Bail-In laws (whilst I touched on this slightly last week I will cover more thoroughly in another episode). I doubt the Government would need to do anything in regards to Austerity to pay back this debt as they can take over banking operations.

What does all this mean?

  • Not many nations have accumulated $1tr in Net Foreign Debt like we have. It’s equivalent to about 56% of our GDP, and is up significantly from 8% in 1995
  • Australia’s banks would never have experienced anywhere near the same degree of asset (loan) growth without the ability to borrow so much from offshore debt markets.
  • The total value of Australian home loan debt would probably not have grown so strongly without this access.
  • Australian house prices would be materially lower as a result – the more people can borrow the higher prices go!
  • The fact that banks can borrow so much is a reflection on foreigners’ confidence in the Australian economy and our ability to repay our debts (AAA rated is seen as safe)
  • The key risk is that the banking system’s ability to continue borrowing from offshore rests with foreigners’ willingness to continue extending credit to them. This is a concern if we lose our higher rating. Few countries should be as worried about the prospect of sharply higher global interest rates as Australia… if rates overseas go up then our repayments will also go up.
  • Too much foreign debt is a huge risk if a financial/economic crisis occurs and foreigners are spooked. For example, if there is a collapse in the price of Australia’s commodity exports, housing market, etc. foreign lenders may think that Australia won’t have the economic capacity to repay the debts (between the banks, the government, and us)

What if this happens? What happens when nobody wants to lend anything more, or we can’t afford the repayments?

  • Austerity (back to Brad’s Question) – a political-economic term referring to policies to reduce government budget deficits through spending cuts, tax increases, or both.
  • Austerity measures are used by governments that find it difficult to pay their debts, particularly when a nation is in jeopardy of defaulting on its bonds (debt instruments). In Australia these include floating rate notes, Commonwealth Treasury Bonds, and other forms of credit totally about $350bn
    • Interest repayments by the Government on this is approximately $17.8bn in interest per year (4% of Gov Revenue). Remember, this is just Government Debt, not including Foreign Debt.
    • Doesn’t seem like too much right? But let’s put it in perspective – the spend on the schooling system (public and private) is $19.5bn a year
    • Maturity of Debt Instruments, just like a mortgage, has a time period within which it needs to be paid back. For example, 10, 20, or 30-year Bonds. At maturity the lump sum borrowed amount needs to be paid otherwise, the debt defaults and we’re at the hands of other nations to be able to repay – who then impose Austerity on us.
      • Greece and Germany/EU – Greece were bailed out, but they were forced to raise the retirement age, adjust pension payments, welfare spending etc.

Foreign Debt Austerity (not really relevant to this)

  • Major risks – Rates rises here (or overseas on the borrowed funds by the banks) – Higher loan costs would lead to less spending, which would affect employment rates, hit the government’s budget, and plunge us into a recession
  • Flow on effect – the Government has less revenue (taxation) so would need to borrow to fund costs
  • It’s very hard in Australia to cut spending, and also hard to raise taxes – And easy solution is to borrow, but foreign debt is stopping this.
  • The flow on effects would be huge, with no one lending to Australia, and nobody wanting to invest here, the currency will drop.

Let’s look at Government debts as this is where Austerity kicks in

What you hear all the time is, compared to other nations, we aren’t in much debt compared to GDP at the national level, so don’t worry!

  • We actually have a 42% Debt to GDP ratio (Gross)
    • Net includes Futures Fund of $146bn – Revenue is $15.6bn – this almost covers interest payments
  • The Japanese government, the world’s most indebted, is the classic case, having borrowed almost entirely from its own citizens. Unlike Japan, Australia’s governments can’t tax foreigners more if they refuse to roll over the loans.
  • This is a simplistic scenario to help break this down – it IS simplistic and doesn’t carry 100% across but helps to illustrate;

Say you are in a household, and your household net income is $100,000 (think of this as GDP)

  • Some relative, friend racks up $42,000 of debt (with interest, so add another $2k)
  • How easily can you pay it back?
  • Relatively easy compared to Japan – $42,000 is better than Japan’s $250,000 debt but comparing bad situation to worse ones isn’t a great excuse to say we don’t have a debt/spending problem
  • Another example; think of it in your own lives. Say you rack up a lot of credit card debt and need to pay it off… where do you cut your budget, or work more?

The Government paying off debt

It would be relatively easy if spending was switched back to repaying debt. It comes back to them having three options 1) Tax more, 2) Spend less, 3) Borrow to bridge the debt repayments.

This is where moralistic flavour enters the debates. People think it’s immoral to spend less in certain areas, others think it’s immoral to tax more. Unfortunately, we’ve seen a popular solution to this of taxing the ‘rich’ more. It’s clearly a popular sentiment in Australia too. But isn’t this still picking on a minority of 1-10% of the population. Morality is relative and really depends on what side of the aisle you’re sitting on.

  • When it comes to policies and politics most of the debate and arguments behind this don’t have even the depth of a Niki Minaj song.
  • So what spending do you cut? Health is $80bn, Education $35bn, Transport/communication $9bn?
  • There’s not much you can really cut from these areas as we have seen a bit of Austerity not too long ago, in 2014/2015. Why do you think Abbot was so unpopular!

The biggest growth in spending, and easiest place to reduce spending …  is Welfare!

  • Welfare payments are at around $180bn a year and is going up to almost $200bn in 2 years (which is 36% of the budget)
  • Technically, we could pay our national debt off in 4 years if we cut out all welfare… but what would that do to our economy?
  • Less money being spent in the economy would cause a decline in some cashflows to business
  • This is the danger of being reliant on the Government
    • Economic Crashes going forward would be debt bubbles created by the Government. A beast of system has been created which is “too big to fail” but there’s more debt around than assets.
    • The Government has the monopoly. They force you to pay more in tax to pay off the debt they have racked up, with little benefit to the population.
    • When you look at the stats globally, there is no correlation between Government Debt to GPD, and personal/individual prosperity.
  • I have no issue with Government debt, as long as it was spent well on things that increase infrastructure/economic growth. But this is not how it is currently being spent or accumulated.

This leads to the bigger point – Why does every nation seem to be indebted?

  • Hear me out. Until 1971 money had to have a sort of fractal backing of gold (was fudged though, creating mistrust in the system) and then the Fiat system was in full force
  • Since then debts gone up for every country. The debt simply represents what someone has lent you so it has to be paid back at some point in time.
  • Looking at Debt to GDP for G20 – Japan, Italy, Singapore, US – All above 100% Debt to GDP
    • Then there were another 10 countries with between 50% and 100%
    • Sum up all debt it’s close $58 trillion USD ($80trillion AUD)… and this is just for the G20 nations!
  • I ask myself, ‘when does this get paid off?’. The GPD of these nations is $65trillion USD
  • This excludes foreign debt!

Total Levels of Debt

  • Government Debt in Australia is $850bn in total which is pretty small compared to private debt.
  • Private – Between Business and Household – almost $3trn
    • This is made up of $1trn Business Debt and $2trn of Household Debt ($1.8trn of which is in housing itself!)
  • The total Credit, including everything as far as borrowing in Australia is concerned, the Australian Receipt is $7trn. This represents aggregated borrowings between private (Household/Business), and Government. It’s all debt in the economy and banking system.
  • Compare that to our total GDP of only $1.76 trillion. Let that sink in.

 

The History of Australian Debt.

Debt has risen massively and with nothing to show for it. Currently we have lower historical wage growth than what we had when we weren’t borrowing as much. GDP growth is a lot less as well.

  • What is the money being spent on? Sadly, lots of unproductive activity.
  • Debt to GDP of 42%. It was under 10% when Howard left office, down from about 33% when he first took office.
  • It is possible to do. But, these days, unless population is wanting it, it’s political suicide!

 

Summary

  • Is possible to pay off this debt but it requires the population’s willingness to do so. It would cause reduction in GDP if spending was redirected but pulls us out of a risky situation in the future if rates do go back up.
  • When you look at the rest of the world, we’re in a much worse position at regarding Foreign debt.
  • In Australia we have a huge external vulnerability via the build-up in non-productive private (mostly housing) debt. It’s a ticking time bomb for the nation – and we’ll look at these risks further next week in Friday’s episode

 

https://www.macrobusiness.com.au/2018/02/australias-foreign-debt-time-bomb/

http://www.australiandebtclock.com.au/

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