I hope I’m wrong, but we’re headed for recession
October 25, 2008 | Maynard Hayek

SYDNEY, AUSTRALIA — For one of the first articles on The Backbench, I don’t like writing about bad stuff.  Particularly when it’s about the “R” word.  The reality is, though, Australia will be incredibly lucky if we avoid a recession.  This is despite Australia facing the global financial crisis with 3 strong-looking levies: (1) a relatively strong banking system; (2) a $20bn commodity fueled budget surplus; and (3) China.  However, as the credit crunch continues to corrode the global economy, more and more pressure is being applied to these levies and their resilience is increasingly being tested.

When the sub-prime crisis began in July 2007, everyone thought it was just a US-centric problem.  Then the wholesale credit markets seized up and people began to see signs of the bloodbath about to unfold. It has been a fascinating and bloody scary train-wreck in slow motion. Who would ever have thought that a Republican ex-Goldman Sachs CEO would bend down on his knees pleading to a Democrat for a government bail-out of his former industry? Or that Iceland, a rich country, would literally melt-down?

The Ponzi scheme of IOUs has exposed many businesses as having fraudulent, sand-castle like fundamentals. In Oz, massive de-leveraging has torn apart names like Centro, MFS, Allco, Babcock, Opes Prime, Tricom and numerous others. Cheap debt and asset-flipping was easy in the good times. But in the bad times, the constant need to sell assets to repay debt, which resulted in further asset-price declines from distressed sellers, which triggered another debt-payment, which triggered more falling prices, has been vicious. Unfortunately, the de-leveraging process is far from over. The latest victims are those who borrowed money to invest in commodities - the ones who thought oil was going to $200 and that commodity prices could continue to hover at record highs while the US and EU economies faltered.

Up until the last month, the view still prevailed that Oz would escape relatively unscathed.  After all, our banking system was rightly proclaimed to be quite strong, with minimal sub-prime exposure.  In particular, the commodity boom appeared to be continuing and China would be our saviour.

Unfortunately it looks like these defences have been breached.  The global financial system almost collapsed. I must emphasise that it really did almost collapse. The failures of AIG, Fannie and Freddie, Lehman and Iceland choked the interbank lending market.  The Aussie Government was forced to guarantee all bank deposits after Ireland blinked first and put-in-chain a series of government bank guarantees. This has resulted in unintended consequences here like the freezing of mortgage trusts.

China’s economy will slow next year.  China’s two main customers are the US and EU and both are in recession, or will soon be.  The Chinese consumer, while growing quickly, will not be enough of a buffer. Less demand for Chinese goods means less demand for Aussie rocks and this has been reflected by the recent crashes in commodity prices and the Aussie dollar.  For Australia, the Great Wall of China will be less of a buffer as initially assumed.

This has prompted the Government to act to stimulate domestic demand.  The serious threat our economy faces is shown by the size of the spending - at $10bn, it’s equivalent to 1% of GDP!  The $20bn budget surplus has now been halved, and may be even less given the likelihood of lower corporate tax.  As we’ll be charging China less for our rocks, the Government is hoping and praying that Aussies spend, spend, spend.

The million-dollar question is unemployment.  It’s currently in the 4% range.  By this time next year, it could be double figures. We’ve already heard about planned job cuts at GE, Optus, Ford and ANZ. Many more will follow.

While Australian banks are amongst the strongest in the world, they do have an Achilles heel. This is their reliance on wholesale funding. ie. Their deposit bases are not large enough to cover their lending activities, which means they have to borrow money offshore. On a street level this means the Australian consumer is borrowing more money than they are saving. In fact, the Australian household is among the most leveraged in the world.  This is the scary stat.  I’ve seen some charts showing us having a greater level of debt vs the US and UK, two countries which are in a much more worse position than we are today.  If unemployment goes to double figures (and in my current negative mood, I think it will), then be prepared for the carnage in house prices.  If people don’t spend, businesses will have to cut costs.  ie. Lay-offs.  If tonnes of people lose their jobs and are unable to pay their mortgage, the current horror stories of negative equity in Sydney’s West (where people’s mortgages exceed their property value) will spread like the plague. An economic tsunami is a real possibility as the effects of household negative equity cascades into the broader economy.

The RBA is scared of this and that’s why they’ve been so aggressive in cutting interest rates.  The Government is sweating on the stimulus to work and for consumption to save the day.  While the Government is currently gaining popularity for its decisive action to address the problem, will the electorate be so forgiving this time next year, if we are in recession?  Will mortgage-belt electorates instead go for Turnbull, who might come across as an arrogant toff, but is a self-made ex-Goldmans banker who clearly has a strong handle on economic issues? At this point in time, I’m more willing to put money on Kevin07 given his strong popularity. But will he be mortally wounded if there is a recession?

It’s not all doomsday.  It shouldn’t be as severe as the Great Depression.  Back then it took a couple of years before the Federal Reserve in the US acted.  This time around the policy response has been much swifter and recently, globally coordinated. Note though that the Fed got us into this mess through cheap money and the Fed’s solution is to drop bucketloads of money back into the system. Noone seems to care that the US will be shouldered with a budget deficit anywhere up to US$1trn in 2009, but this is a topic for another post.

The collapse of the AUD also means our exports are cheap.  However, unlike in the Asian Financial Crisis, when our exporters could switch from Asia to the US and EU, this time we have to rely on Asia.  Asia, while unleveraged and fundamentally sound, may spook itself into recession. ie. Asian consumers see that everyone else is in recession, become negative and stop spending. There will be some buffer however, from Aussie tourists spending their hard-earned (or should that be maxing out their credit cards) at home.

So watch the Aussie consumer.  How busy will shops be during Christmas time?  Will the hand-outs be spent?  The number of Santas taking photos will be a good indicator. You may even see Kevin07 don a beard and a red suit nervously “ho ho ho-ing” as he watches and wills on the shoppers to spend.  Fingers crossed that they spend up.  Unfortunately I don’t think this will be the case.  I hate to say it, and I really hope I’m wrong, but I presently think 2009 will see a recession.

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Maynard is a paper-shuffler and tea-leaf reader.

Article posted on Saturday, October 25, 2008 at 8:48 pm in Business & Finance, Politics