MAKING NEWS

Sat, 02 August 2008
Debt mutes the horn of plenty


THE combination of rising interest rates and the global credit crunch has pushed the economy to the brink of recession. Consumers have reined in their spending and borrowing, while businesses are finding it hard to get the finance they need to proceed with investment projects. Consumer and business confidence has been falling for months along with the partial indicators of demand, such as retail sales and housing finance approvals.

The Reserve Bank has been cautiously pointing to the signs of slowing demand since March. What has changed views over the past week is the speed with which conditions appear to be deteriorating.

The National Australia Bank's business survey had profits, sales and employment at record levels in January. The survey it released last week showed businesses expect a recession over the next 12 months.

Business borrowing was booming at an annual growth rate of 25 per cent between July and January. Over the past three months, it has been rising at an annual rate of only 3.6per cent.

"The speed with which the economy has turned around is sharper than you've seen in the soft landings of the mid-1990s and early this decade. It is more akin to the end of the '80s, heading into the last recession," says ABN AMRO chief economist Kieran Davies.

He attributes the speed of the downturn to the "tightening in financial conditions". This includes not only the official and unofficial increases in rates, but also the toughening of lending standards by the banks.

This is hitting households as well as businesses. Home buyers can still get a mortgage, but not if they've got only a 10 per cent deposit, as was the case until early this year. In the second half of last year, the banks were welcoming new big business customers with open arms, as companies found they could no longer tap world financial markets with their own bond or commercial paper issues. But then the banks got scared.

They have to set aside twice as much capital for business loans as for mortgages. The banks are trying to conserve as much of their capital as they can because of a fear that over the next year or two they may face large write-offs. "We keep hearing anecdotes of good businesses with good projects that are finding it difficult to get finance," Davies says.

Tumbling share markets have made it hard for companies to access capital there, while they have also contributed to the loss of consumer confidence.

ANZ Bank's chief economist Saul Eslake notes that the Reserve Bank was planning for a sharp fall in consumer demand. In the second half of last year it was growing at a rate of close to 6 per cent: "Reading between the lines of the Reserve Bank's forecasts, it expected that to slow to something well under 2 per cent in 2008. That is a very abrupt slowdown in domestic spending."

Eslake says there are still some positive factors that could change the outlook in the second half of this year.

The tax cuts, which were more generous than any handed out by the previous government, are just starting to filter through into household hands. The petrol price, which contributed to the collapse of retail sales in June, is falling. And the benefits of the new contracts for iron ore and coal are just beginning to flow through.

Eslake puts the chance of a recession at no more than 25 per cent, saying that although consumers are pulling their heads in, there is enough business investment and exports in the pipeline to keep growth positive.

Consumers may feel as if there is a recession, but the long-awaited lift in export volumes could mean that Australia slips past the technical definition of two quarters of negative growth.

"The risk of a recession is small but it is rising and is probably closer than at any time since we were last in one," he says.

Even the US, which has been the epicentre of the world financial crisis, has so far kept economic growth in positive territory. But as the International Monetary Fund has stressed, the crisis still has a long way to run, with no sign yet that the downturn in housing in the US has hit bottom.

It is housing that is the soft underbelly for Australia's economy. For 20 years, Australian households have been rapidly raising more debt and using the lion's share of it to buy housing. Debt has risen at an average annual rate of about 15 per cent, more than three times as fast as income.

In 1988, the average household had debts totalling 32 per cent of its income. Now the average is 160 per cent.

It is the elevated level of household debt that has made consumers so sensitive to moves in interest rates, and which has the potential to pitch the economy into a much more difficult downturn.

The global financial turmoil has been described as a process of deleveraging. Sectors of the economy that had built up excessive debt are being forced to wind it back.

"Deleveraging can only occur in two ways," Eslake says. "People can repay debt, perhaps by selling assets and using the proceeds to repay debt or by saving more. Or else they can default, and that is a process with serious consequences."

The housing market has turned. Demand is falling while supply is increasing. The number of sales is down and prices are starting to weaken. Michael McNamara of Australian Property Monitors says the figures on the number of sales come through slowly. As of March, they were down by 25 per cent.

There are more unsold properties on the market, with 225,000 properties listed for sale, up from 200,000 a year ago. The number of housing loans for new purchases is down by 7.1per cent.

Morgan Stanley chief economist Gerard Minack believes prices will come down 20 per cent to 30 per cent. He does not accept the argument that housing is in short supply or that high rates of migration will support the market, saying that if houses are not affordable, they will not be bought.

"We are in the process of bringing the curtain down on what has been a super cycle for the Western world's financial institutions, which was built on the willingness of consumers to increase their leverage at fantastic prices," Minack says.

Financial deregulation and an extended period of low interest rates added fuel to the fire. "The escalation in leverage over the past 20years is completely off the scale. It is bigger than the 1890s property boom and bigger than the 1920s. It is bigger than anything we've ever seen, and I think we've reached the limit of how far these trends can go. The unravelling will be extremely painful."

Minack says there is a huge momentum in the growth of borrowing: even with the slowdown, households have $95 billion more debt now than they did a year ago.

There is a danger that what were virtuous cycles during the boom could become vicious in the bust.

Banks that were encouraged to lend by rising asset prices become fearful when prices fall and tighten their lending standards, frustrating the efforts of the central bank and government to stimulate the economy.

Attempts by households to reduce debts can result in a fall in housing prices, putting consumers under greater pressure to reduce debt. The growth in household debt has a counterpart in rising foreign debt, which stands at roughly $700 billion.

Bank deposits have not been enough to fund the rise in household borrowing, so the banks have turned to world markets, which have been more than willing to lend. They are still willing, albeit at a much higher interest rate than was being charged a year ago.

"The funding costs can only get worse if we see interest rates come down here and the currency starts to fall, so that the attractiveness of lending to Australia diminishes," Minack says. The economy may hover along at a reduced but still positive pace of growth for several more quarters.

The darker concerns are for 2009, when the pain of falling share prices is more likely to be compounded by falling house prices, while business will be cutting staff.

In its review of global financial stability released last week, the IMF's head of capital markets Jaime Caruana said the US sub-prime crisis was no longer the greatest threat to the world economy.

Rather, it was that a weakening world economy would reduce the banks' capacity to lend, which would further undermine growth.

Reserve Bank governor Glenn Stevens and Treasurer Wayne Swan have stressed the strength of Australia's banks as our bulwark against the global financial turmoil. However, they are not masters of their funding costs and their effort to correct for the years of plenty may yet pull the economy down.



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