Buckle up Dorothy. Kansas is going bye-bye.
The warnings of an impending financial crisis are starting to come in from all corners. So, maybe they’re worth listening to. If the warnings materialise, Australia looks to be lining up for something much worse than anyone is anticipating, and we may not escape quite as easily as we did during the GFC.
According to Carmen Reinhart and Kenneth Rogoff – who studied eight centuries of financial crises in their New York Times bestseller, This time is different – there are four leading indicators of a crisis. I have also recorded a video which you can access here.
The first is a rapid inflation of asset prices, particularly residential housing.
The second is excessive debt accumulation, either by the government, banks, businesses or consumers. The accumulation of debt almost always poses greater systemic risks than it seems during the boom, and the injection of cash makes the growth that results look more sustainable than it really is.
The third is outsized borrowing from abroad and reflected in a sequence of gaping current account and trade balance deficits.
Finally, the occurrence of slowing economic output.
Reinhardt and Rogoff studied eight centuries of financial crises and the above four factors are a strong signal of an impending financial and or banking problem. Of course nobody is talking about the possibility of a crisis in Australia right now but three of the above four factors are in place. And if you believe the oversupply of apartments will be followed by a decline in residential construction activity, then deteriorating levels of economic activity are almost certain.
That would make four from four.
It goes without saying that property prices are going a little bananas in Australia. We have warned investors about the housing bubble now for a year and it’s getting worse. Even the Reserve Bank of Australia is telling apartment investors to be very, very cautious. Of course the bulls believe house prices cannot fall (factually incorrect), that Chinese buying will support prices (flawed weight of money argument) and that we are running out of land (high rise residential developments ensure millions of people can all live on a smaller piece of land and Singapore, the Middle East and the gold coast have demonstrated an ability to reclaim land from the sea.
The history of financial crises also reveals that borrowing binges occur. In Australia today, household debt to GDP is rising inexorably. In 2014, household debt to personal income in Australia was a record 206% and has risen since. Household debt to GDP is approaching 130%. In the United States this ratio had been stable at 80% of personal income until 1993 before jumping to 120% in 2003 and 130% in 2006 – the year before their crises began.
It’s worth noting that work conducted by Bordo and Jeanne (2002) and the Bank of International Settlements (2005) confirmed that when housing booms are accompanied by sharp rises in debt, the risk of crisis is significantly elevated.
Over two decades, Australia’s household debt has increased more rapidly than household income. In 1990 household debt to income was 56%, by 2002 it had reached 125%. By April of 2014 it reached 177%. And according to the OECD it now sits at 206%.
And the inexorable rise in credit card and mortgage debt means that Australians have simply taken on more debt, typically to chase more expensive houses, and have less money to pay for it all.
The third criteria is a rising current account deficit. Those who might suggest ‘this-time-is-different’ will point to globalization, for the rising current account deficit, that allows much larger surpluses and deficits to be carried.
Investors should remember, however, that a current account deficit simply means revenue from exports is insufficient to meet the cost of imports.
An examination of all 19 bank-centered crises since WWII reveals that the average current account deficit increases from 1% of GDP four years before the crisis to 3% of GDP in the year prior to the crisis.
In 2015, Australia recorded a current account deficit of 4.6% of the country’s Gross Domestic Product, compared to an average of 3.24% since 1960.
In the US, prior to the GFC, outsized financial returns were in fact greatly exaggerated by capital inflows. In Australia today it could be argued that property returns are also greatly exaggerated by foreign capital inflows and for stock market investors the returns from dividends might also be exaggerated by the unsustainable dividend policies of companies that are failing to reinvest for future growth.
From the 19 post war banking-centred crises studied by Reinhart and Rogoff, they conclude that markedly rising asset prices, slowing real economic activity, large current account deficits and sustained debt accumulation (whether public, private or both) are important precursors to a financial crisis.
A week or two ago, in a report entitled Debt, Use it Wisely, the IMF’s Vitor Gaspar warned Australia over its soaring debt, alongside Canada and Singapore. Mr Gaspar also warned Australia’s policy makers against complacency. “History has taught us that it is very easy to underestimate the risks associated with private debt during the upswing.”
Australia’s residential property construction boom is helping Australia’s economy but it is also masking a problem it is itself creating. When an oversupply of apartments causes the prices of those apartments to fall there will be a slowdown in production (just as there was when iron ore became oversupplied and many thought that boom would last forever too). When production slows down, fewer active construction sites means people lose jobs, spending contracts and the banks may find themselves holding mortgages whose profitability was built on hot air.