Regarding the current drama in Europe, if the European authorities does nothing (or stoically refuse any thought on moral hazards), the world will get a GFC II, in which Australia may not be so lucky this time round. Our guess is that when push comes to shove, the Europeans will eventually print money and kick the can further down the road. After all, with the nightmare of the Panic of 2008 still fresh in their minds, they will not repeat the ‘mistake’ of acting too slowly. The outcome will be more moral hazards and monetary inflation, which is something we and our children will pay down the road.
Meanwhile, as the global financial markets are fixated over the current sovereign debt crisis in Europe, contrarian investors (especially Australian investors) should look at another part of the world for any potential mishaps- China. Starting from January this year, the Chinese government had been tightening the supply of credit. Measures include turning off the credit tap to increasing bank reserves requirements. Recently, unlike 2008, the Chinese government seemed to be getting really serious about cracking down on property speculation, even to the extent that it is giving the impression that it wants the property bubble to burst (see Is China’s Stock Market Crashing?).
As we wrote in Marc Faber: Beware of investing in Australia (as it follows the Chinese business cycle), with all these tightening measures, China will slow down this year. The question is, will the Chinese government accidentally over-tighten cause a crash instead? Remember, its objective is a soft-landing (which they managed to pull off in the 1990s under ex-premier Zhu Rongji). But will they end up going too far, resulting in a hard-landing?
Only time will tell.
But if it happened, you can sure that Australia will have a very ride. As we warned our readers a few months ago in Hazard ahead for Australia- interim crash in China,
Therefore, investors should understand this basic principle: because of the leverage that Australia is exposed to China, any slowdown in China will have a leveraged effect on Australia.
The first effect of an economic slow-down in China will be a fall in base metal prices. Already, there are some signs that base metal prices are cooling off. For example, copper prices are approaching the lows made in January this year. If China crashes, we can expect base metal prices to crash too.
Next, given that the Australian dollar (AUD) is seen as a commodity currency, it will fall. This is to be expected as Australia’s terms of trade and business cycle is closely tied to Chinese demand for commodities, which in turn is tied to the business cycle in the Chinese economy. A crashing Chinese economy will be likely to test the AUD as it was tested in 2008. Mining companies in general will not do well in such an environment. In fact, speculators like Jim Chanos will be shorting the Australian mining stocks (see How is Jim Chanos going to short China? (Australia: take note)).
Then, with the deteriorating terms of trade (due to falling Chinese demand), the Australian economy will slow down. With that, there will be speculations (and hope) that the Reserve Bank of Australia (RBA) will be cutting interest rates.
If China’s coming slowdown is just a soft-landing, then the story may end here. But if it’s a hard-landing, then there will be more complications. In that case, Australia is very likely to have a hard landing too. This is where we are getting nervous. The critical thing to watch out for is Australia’s unemployment rate. As we wrote in RBA committing logical errors regarding Australian household finance,
Given Australia?s high household debt (see Aussie household debt not as bad as it seems?), prime debt can easily turn sub-prime when unemployment rises. As unemployment rises, it will eventually reach a critical mass of prime debts turning sub-prime.
Given that Australia’s highly leveraged banking system is heavily concentrated on mortgages (Black Swans lurking around Australia?s banking system), there will be a tipping point in the unemployment rate that will trigger a banking crisis. That in turn may trigger a currency crisis (see Will there be an AUD currency crisis?).
If there is an AUD currency crisis, the RBA will be in a quandary. Should it cut interest rates further to support the domestic economy (and condemns the AUD)? Or should it raise interest rates to defend the AUD (and condemn the domestic economy)? This was what Iceland faced in 2008- high inflation, collapsing currency and rising unemployment. The Icelandic central bank had to raise interest rates to defend its currency. Remember, a collapsing AUD implies that the price of oil imports in AUD will sky-rocket (limited to the extent that oil prices are falling due to reduced Chinese demand). As you can read in Five potential emergencies- energy crisis, this will be extremely disruptive to the Australian economy.
Of course, the scenario that we painted is extreme. But after having read and understood Nassim Nicholas Taleb’s The Black Swan, we learnt not to say “never.” Hopefully, the outcome will not be that bad. But for those who want to be prepared, we highly recommend How to buy and invest in physical gold and silver bullion.
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