Posts Tagged ‘Australian dollar’

Bank for International Settlements (BIS) warning on stimulus spendings

Sunday, July 5th, 2009

This week, the Bank for International Settlements (BIS), which is known as the central bankers’ central bank, warned governments all over the world from getting carried away with economic ‘stimulus’ spending. The BIS is the only international body that had correctly anticipated the global financial crisis (GFC) and warned of another great depression back in June 2007, when they released their 77th annual report (see Bank for International Settlements warns of another Great Depression).

In the 79th annual report, they warned,

Perhaps the largest short-term risk associated with the expansionary policies is the possibility of a forced exit. Monetary and fiscal authorities of the major economies have so far been relatively unconstrained in their ability to follow expansionary policies. This need not last. An extended period of stagnating economic activity could undermine the credibility of the policies in place. Governments may find it hard to place debt if market participants expect the underlying balance to remain negative for years to come. Under such circumstances, funding costs could rise suddenly, forcing them to cut spending or raise taxes significantly. External constraints could also bind for some countries. Particularly in smaller and more open economies [e.g. Australia], pressure on the currency could force central banks to follow a tighter policy than would be warranted by domestic economic conditions.

In other words, if economic stimulus spending failed to re-ignite economic growth, the bond vigilantes will lose their patience and make governments accountable. This means they will sell down government bonds, resulting in rising long-term interest rates. As a result, governments will find it harder and harder to raise money to spend in order to ‘stimuluate’ the economy further.

From this point, there can be two choices for governments:

  1. Cut spendings and raise taxes
  2. Print money

In a stagnating economy (with high household debts), we doubt the government will have the guts to undertake option (1). In Australia, judging from the howls of protests over the latest budgets, it is clear that the masses will not tolerate government austerity. The only alternative will be to undertake option (2)- printing money.

For countries like Australia, as we highlighted in bold in the above quotation of the BIS report, there is an added risk. Should there be any run on the Australian dollar, the RBA will be forced to raise interest rates regardless of how bad the domestic conditions are. With the Rudd government promising the moon (see Australian government?s contingent liability to exceed AU$1 trillion),the risk is that should they be required to deliver the moon, the Australian dollar will come under immense pressure and the Australian government bonds can be relegated to junk bonds.

At this point in time, the BIS is not sure whether stimulus spendings will work,

An open question as of this writing is whether the expansionary set of policies enacted in response to the sharp contraction in economic activity in late 2008 and early 2009 will succeed in stabilising the economy. A major cause for concern is the limited progress in addressing the underlying problems in the financial sector. The experience of the Nordic countries in the 1990s and other historical episodes suggest that a precondition for a sustainable recovery is to force the banking system to take losses, dispose of non-performing assets, eliminate excess capacity and rebuild its capital base. These conditions are not being met. A significant risk is therefore that the current stimulus will lead only to a temporary pickup in growth, followed by protracted stagnation. Moreover, a temporary respite may make it more difficult for authorities to take the actions that are necessary, if unpopular, to restore the health of the financial system, and may thus ultimately prolong the period of slow growth.

Without the financial system restored to health, it will result in economic stagnation, which will result in even more government economic stimulus, which eventually can only be financed by printing money. Evemtually, if this goes on, it will be, as we wrote in Supplying never-ending drugs till stagflation

Like drugs, the more you ?print? money, the less effective it will be in stimulating economic growth (see What causes economic booms and busts?). Eventually, it will come to a point that the economy will not respond positively anymore no matter how much money is being ?printed.? That is the nightmare of stagflation (low or negative real growth with sky-rocketing price inflation- look at Zimbabwe).

Currently, we are in this “temporary pickup in growth” stage.

What should the ‘evil’ savers do?

Sunday, June 14th, 2009

In our previous article, What goes in the mind of the Rudd government as it extends FHOG?, Rebecca asked the following question:

I was wondering, can you guys make any suggestions on what potential first home owners OUGHT to be doing INSTEAD OF leaping upon the FHOG [free cash (of around $14k to $21k) that Australian government gives to first home buyers]? This reader may, uh, be personally invested in the answer to such a question 😉 but I bet a lot of others are in the same boat: people who’ve been saving saving saving only to have the cheese moved $21,000 ahead again (thanks KRudd!), and now face the possibility of having their hard-saved future deposit decimated by inflation because it’s still liquid rather than sunk into bricks and mortar?

Assuming stable employment (easier said than done, but run with me here), isn’t the property market almost a safe bet now just because Kevvie’s obviously bailout-happy and presumably knows he’s not going to be very popular if he lets all the first home owners he made go under, so is likely to keep on bailing?  Does the traditional advice that a person save a good deposit apply any more when the only way to save your money is to have it invested in property or some other format that’s not going to get devalued should inflation occur? What else can one do to escape being a victim in this whole mess simply through being on the poor end of the spectrum and trying to do the right thing and be responsible?

Basically, as Rebecca asked, let’s say these 3 conditions are satisfied:

  1. Assuming you have a guaranteed stable job (if we read Rebecca correctly, other people are not in this envious situation).
  2. The government will succeed in enticing people to go deeper and deeper into debt to bid up property prices higher and higher.
  3. If those who are enticed into debt default, the government will bail them out.

Wouldn’t this result in property price rising further and immune to a price crash? If that’s the case, should savers gouge themselves in debt instead because the government is committed to moral hazard?

[Note: some parts of what follows are a bit of sarcasm and humour- so, don’t take them too literally.]

Sure, it can be very cheap and easy for the government to engineer further property price inflation. The FHOG is an example of that. The government needed to fork out a relatively small outlay to result in a much larger increase in borrowing, which helps to inflate property prices even more. To see why, imagine a borrower has a $1000 deposit. At 90% LVR, he can buy a house that cost $10,000. Let’s say the government give the borrower another $1000. At the same LVR, this borrower can now pay $20,000. Thanks to the powers of leverage, a $1000 outlay from the government result in an increase of $9000 in debt.

Sure, in the event that the sh*t hit the fan for the Australian economy, the government can bail out defaulting sub-prime borrowers willy nilly and prevent a property price crash. They can print copious amount of money (until Australia runs out of paper), invoke emergency powers to prevent repossessions, confiscate the wealth of savers to bail out irresponsible defaulters, nationalise banks, and so on.

The problem is, if the sh*t hit the fan for the Australian economy AND the Australian government engage in such extreme moral hazard, Australia will become a big banana republic and the Australian dollar will have less value than toilet paper. Foreigners lend a lot of money to Australia and they will readily punish any extreme moral hazards. In that case, all Australians will lose big time, especially savers. And also, a property is not recommended in such an environment because:

  1. One cannot carve out a tiny fraction of his property in exchange for food.
  2. There are much better hedge against hyperinflation than property- gold and silver. The reason is because credit will be scarce in a hyperinflationary environment because lending money is a losers’ business. If credit is scarce, what do you think will happen to property prices in real terms?
  3. As lenders raise interest rates to match the rate of hyperinflation AND one loses his job, one is essentially stuffed (unless the government bails him out).

So, if you believe Australia is going towards that route (it may not be as extreme as the scenario that we painted, but you get the idea) and you want to protect your savings, you may want to diversify part of your savings away from Australian dollars (as well as any assets denominated in Australian dollars). Ideally, such diversification should transfer your wealth to foreign countries, where the foreign government is in a position to respond with a “stuff you” to any Australian government’s demands for information about your foreign assets. For example, you may want to consider foreign currencies (preferably in foreign banks out of reach of the Australian government), physical gold and silver (stored overseas or buried in some secret treasure island guarded by dragons), foreign assets and so on. Lastly, if the masses and government persecute the evil savers the same way the Nazis persecute the Jews, be prepared to migrate.

Please note that we are not trying to be unpatriotic here. Our point is that, if politicians resort to extreme stupidity, they can easily turn a nation into a banana republic in record time. Just ask how Robert Mugabe did it by turning the bread basket of Africa into a starving and improvished nation.

What will happen if RBA cuts to zero?

Tuesday, February 10th, 2009

In the United States, the Federal Reserve had set the interest rates to almost zero. In the United Kingdom, interest rates have reached 1%. Japan had cut her interest back to almost zero again. Canada’s interest rates have reached 1%. In Europe, it’s 2%. All over the world, central bankers are busily firing their interest rates guns to fight this global recession. Already, Japan and the United States had already ran out of ammunition.

As for Australia, the goods news is that our Reserve Bank of Australia (RBA) still has some ammunition remaining after cutting its rates to a low of 3.25%. The bad news is that Australia is about to enter recession, possibly a very severe one (see Realisation of hard landing ahead for Australia). So, what if Australia’s RBA runs out of ammunition too?

If Australia’s interest rates ever reach zero (as Professor Steve Keen believes it will by 2010), it will happen in the context of a hard landing or even a depression. It will be a time of debt deflation, which as we said in Aussie household debt not as bad as it seems?,

A severe downturn to the Australian economy may or may not be statistically likely, but given the level of unprecedented leverage, you can be sure the impact will not be small. Be sure to understand the concept of Black Swans (see Failure to understand Black Swan leads to fallacious thinking).

Chances are, such economic malaise will drag on for many years, similar in length to Japan’s lost decade. For investors, this will be a very trying time. The key thing for investors and savers to watch out for is the Aussie dollar. As we explained before in Can falling interest rates and rising mortgage rate come together?,

A large fraction of Australia?s borrowed money is sourced from overseas through the ?shadow? banking system. In other words, there are not enough domestic deposits to fund all the needed credit (e.g. home loans) in this country.

As a result, there is a great potential for a complication that we described in Another complication in RBA?s interest rate cut,

Today, we will talk about another issue that can complicate matters for the RBA- the pullout of foreign capital.

When debt deflation takes hold of Australia, the RBA can easily run out of ammunition. In the absence of government intervention, credit will be extremely scarce in Australia. Our guess is that in such a scenario, foreign capital will flee out of Australia, leading to another fall in the Aussie dollar. The only mitigation against our dollar in such a scenario will be to the extent that the Australian government opens up our mining and resource assets to predatory foreign sovereign wealth fund (read: China).

Everything else being equal (we will talk about the not-being-equal scenario further down), a falling dollar will be, as we described in Falling currency and inflation,

Now, we will look at the context of Australia, which is another import-dependent country. A rapid depreciation of the Aussie dollar will result in rising price inflation for the same reasons stated above.

Now, imagine the food that you eat everyday. Most of them are produced in Australia. A falling Aussie dollar implies that foreigners will have greater purchasing power for Australian-made food. Assuming that the market is still free, that means that Australians will have to compete with foreigners for our own food. Also, since Australia is hardly self-sufficient in manufactured goods, a falling Aussie dollar will imply falling purchasing power for the many imported things that we enjoy today.

What if we combine debt deflation with falling Aussie dollar? In that case, there will be massive aggregate demand destruction in the economy. Basically, this means a very drastic drop in the standards of living for many.

We shudder to think of the implication of this. We wonder whether there can be a scenario whereby there is a combination of (1) crashing asset prices (due to debt deflation) and (2) rising inflation for price inelastic consumer staples (due to the depreciating Aussie dollar)? If such an mishap eventuates, even savers have to worry about the return of their savings!

Are some Aussie resource stocks oversold?

Thursday, September 11th, 2008

Over the past couple of months, we are witnessing price deflation almost all asset class, including commodities. This huge falls in commodity prices is hardly surprising. As we explained back in March 2007 in Warning: gold price can still fall significantly,

When the inevitable liquidity contraction occurs, gold price will fall as well.

18 months had gone past since that article was written. Today, we are witnessing the deflation that we had been waiting for. In this deflation, commodity prices in general are falling. It is in this context of falling commodity prices that many Australian resource stocks are falling, especially the smaller cap ones. Many of them are even falling below their 12 month lows. The market’s logic is that falling commodity prices imply falling revenue and therefore profit will fall.

Is this logic correct?

First, commodities are priced in US dollars and they are falling in terms of US dollars. Next, the Australian dollar is perceived to be a commodity currency and tend to have some correlation with commodity prices. In that context, as commodity price falls, the Australian dollar tends to follow along to a certain degree.  At this time of writing, the Australian dollar is worth of US$0.795. In just 1 ½ months, the Aussie dollar has fallen almost 20%!

Therefore, in terms of Aussie dollar, the fall in commodity prices is not as bad as it looks. However, some costs may rise may rise due to rising price of oil in terms of Aussie dollars. Everything else being equal, a falling Australian dollar is actually good for the bottom line of resource producers.

Thus, if you look at some of the massive falls in some of the smaller resource stocks, it looks that they are being oversold.

RBA’s interest rates dilemma

Wednesday, September 3rd, 2008

Yesterday was the first time in several years that the Reserve Bank of Australia (RBA) decided to cut interest rates. As you can read from the mainstream news media, this fall in interest rates is not necessarily good news. For example, Ross Gittins from the Sydney Morning Herald said in Yippee, the bad times are back,

YOU beauty. Interest rates have been cut and happy days are here again. For good measure, we’ve even got petrol prices coming down.

Sorry, don’t be too sure about that. The Reserve Bank has cut its official interest rate only because times are getting tougher.

But our loyal readers should already know about this fact long time ago. Back in July last year (2007), when the talk in the market was still about booming asset prices and inflation, we warned in Should you purchase first home whilst asset price inflation?,

… it is prudent to arrange their finances with the assumption that interest rates are going to be in an upward trend for at least in the medium term. Having said that, it is still possible for interest rates to be cut? when the economy is hit by a threat of recession or depression

While those heavy in debt would welcome RBA’s interest rate relief, there are still many unresolved complications. The most important thing to remember is that Australia’s price inflation problem is still not yet resolved. The RBA is forecasting rising price inflation till the end of the year at least. Normally, no central bank will cut interest rates in the face of rising prices. But this time, they have a bigger worry than rising prices- economic recession. In other words, Australia is facing stagflation (economic stagnation/downturn and rising prices) and the RBA is more worried about the ‘stag’ part of the stagflation. And they are betting that the ‘stag’ part will somehow resolve the ‘flation’ part.

But from what we can see, the RBA’s hands are tied. If they try to prevent the slowdown from turning into a rout by slashing interest rates aggressively, it is very likely that the Aussie dollar will continue its down trend. As we explained before in Falling currency and inflation,

A rapid depreciation of the Aussie dollar will result in rising price inflation for the same reasons stated above.

We do not envy the job of the RBA. It looks like Australia may be moving towards the same path as the US (see Supplying never-ending drugs till stagflation).