Australia guarantees all domestic bank deposits

Note to readers: I have added a brief postscript at the end of this post on the competitive implications of the Australian move.

According to breaking news reports, Australia will guarantee all bank deposits for three years and guarantee wholesale funding to Australian banks in an attempt to combat the global credit crisis. Australian will also double the funds available for mortgage-backed securities to $8 billion to help maintain liquidity for non-bank lenders. The move is apparently being coordinated with New Zealand.

The Australian move has been driven in part by competitive pressures following guarantees by other countries. Australian Prime Minister Rudd said while Australian banks were well capitalised and well regulated, the measures were needed to help Australian banks compete with others in the international market.

Under the plan, all deposits in Australian banks, building societies and credit unions, will be guaranteed by the Australian government for the next three years. Deposits in Australia tally between $600 billion and $700 billion, Mr Rudd said.

In return for the guarantees, banks would have to pay an insurance premium levied at an appropriate rate determined between treasury and the banks to ensure, in Mr Rudd's words, that this is not simply a free gift from the government by way of a guarantee to the banks.

The government will also guarantee term wholesale funding to local banks until global financial markets stabilised. This means according to Mr Rudd that anyone lending money to an Australian bank has an assurance their money is safe.

Postscript

I have been watching the media comments on the Australian move. While there has been a lot of blog commentary, the main stream international media while noting the announcement has largely focused on what they see as the main game.

The Australian move will not affect stock exchange prices, Australia is too small a player, but it does have interesting implications.

At a purely domestic level, it effectively takes Australia out of the direct effects of global financial trouble. Australia will still be affected by global downturn, but the financial crisis should no longer be relevant to domestic financial market forces. Policy can instead focus again on economic fundamentals.

At a second level, it is likely to enhance the global competitive position of Australian financial institutions, something that the Australian Government clearly had in mind. The end effect here depends upon actions by other countries, but the effect is still likely to be positive.

All this, of course, depends upon the validity of my assumption about the soundness of Australian banks.

If, as I believe, there is not a problem, then the Australian move has little risk. The Government is in fact likely to make a profit out of the whole thing. If I am wrong, then all bets are off.

Finance 101 and the global financial crisis

A short post just to mention that I have continued my on-going discussion on the global financial crisis in a post on my personal blog, Saturday Morning Musings - finance 101 and the global financial crisis. My end point in that post was:

To my mind, we should consider putting a bullet through the entire current corporate control and reporting system. It does not and cannot work. Instead, we should focus on what we really want to achieve.

The problem we have at the moment is that we fix things by changes at the margin when we should in fact be replacing the whole system. The last sentence, focusing on what we want to achieve is, to my mind, critical.

Australia and the global financial crisis

The graphic shows the latest IMF projections for world growth. Those interested can find full details here.

There is a dreadful fascination in watching the global financial crisis unwind. I wish I had a spare billion or two to invest at a personal level just at present. There are some interesting investment opportunities emerging.

I must say that I find some of the continuing discussion confusing because it mixes together so many very different issues. It is quite hard to stand back and look to the longer term.

This post is intended to clarify my own thinking.

Financial vs Real Economy

In Why the US financial package should be rejected - and why Australia will ride out the storm I suggested that one problem with the US Rescue Package lay in the way it mixed together two very different things. The first was the maintenance of liquidity, I should add here the restoration of confidence, so that financial institutions could lend to each other. This was a good thing. The second appeared to be the maintenance of US property values. I thought that this was plain silly.

Economists usually make a distinction between the financial and real economies. One of our problems just at present is that the two have got out of kilter along three dimensions.

Dimension one is a shift in the relative size of the two. The sheer volume of transactions dwarfs the physical economy. One consequence has been greater instability in key markets on which the physical economy depends. The current financial crisis is but one, if the largest, in a long series. The traders have acquired a life of their own.

Dimension two is the way in which the financial markets have supported, leveraged, the growth in value of certain types of assets. During the long boom period, this supported rises in corporate and consumer debt, in turn fuelling demand. However, the process also resulted in a growing gap between the real sustainable value of assets and market prices.

Dimension three is the growth in the size of the financial sector itself within the real economy.

If you look at the attached chart from the New York Times, you can see that over the last thirty two years, the finance sector's share of total US wages and salaries rose from just over 5 per cent to 9.8 per cent. During that same period, its share of US corporate profits rose from around 17 per cent to 27.4 per cent.

What goes up is likely to come down. The problem we now have is that all three dimensions have gone into reverse at the same time. Leveraged growth has turned into leveraged decline.

I am not saying anything new in any of this. However, I am not sure that people fully realise the implications.

In past busts of this type, one outcome has been a relative decline in asset prices until a new value equilibrium is reached. This creates pain, but also lays the basis for subsequent growth. The scale of the problem this time, the way in which de-leveraging has been wiping out corporate and individual value in certain countries, creates a desire to try to maintain asset prices.

The problem here is that success is likely simply to prolong problems. We may stop collapse, but many countries may face stagnation until real equilibrium in asset values is restored.

Australia remains the lucky country in all this. We have a long history of booms and busts. We were not immune to the global financial boom. However, this time a number of things have combined to work in our favour. Here three things are of particular importance.

The first has been our improved terms of trade as a consequence of rising food and commodity prices.

Australian commentators have talked about the emergence of a dual economy, a flat economic sector especially in NSW on one side, booming resource economies on the other. What is, I think, less clear, is that this has cushioned an adjustment process that began some time ago.

As an example, Australian residential construction is close to record lows because of the end of the previous housing boom, but the economic effect has been contained. Our worry now is how to expand housing, not to preserve asset values but to meet a rental shortage.

The second thing working in our favour is that our excesses were simply less. As a consequence, we do not have the type of systemic problems that exist in some other countries. Among other things, this means that Australians are (so far at least) simply not worried about domestic bank crashes. It just won't happen.

This links to the third thing working in our favour, the way our official systems have worked.

Worried about excessive demand and potential inflation, our Reserve Bank has been tightening monetary policy for some time. Over the last few years, we have seen interest rates rise steadily as the Bank sought to contain the economy. With high interest rates by world standards, there is now scope to cut.

At fiscal level, the booming economy has allowed for budget surpluses and debt repayment. At national level, we have no net official debt. I have argued that this process has gone too far, but no-one can argue that it has not put us in a strong position to use fiscal policy to support expansion if we need too.

One interesting side-effect that I had not focused on is that Australia now has the sixth largest Sovereign Wealth Funds in the world. I have not written about this before, but should do so. Australia also has a large and growing pool of investible funds because of the impact of the superannuation guarantee levy.

All this means that we are in an unusually good position to ride through current troubles.

Shifts in the economic tectonic plates

If you look at the IMF projections, you can see that the IMF believes that while developed economies will enter recession, growth will continue in some of the developed economies including India and China.

As I see it, the current global financial crisis is like an earthquake marking a shift in the economic tectonic plates. As part of this, the share of the global economy held by the big emerging economies will increase.

Of course they will be affected by the downturn. We can see this in China already with downturns in certain sectors linked to export markets. I actually think that the impact will be greater than the IMF allows. However, it remains true (as the IMF suggests) that these economies have significant capacity to expand domestic activity to compensate.

From the viewpoint of China, the current downturn may be a blessing in disguise. China has been suffering from rising input costs. These were going to squeeze some export activities anyway. The global downturn provides China with the opportunity to expand domestic investment and consumption at a lower price than might otherwise be the case.

Australia may suffer in the short term because of lower commodity prices, but we can still make a fair bit of money.

Conclusion

I suppose my key point in all this at global level is that we need to keep a sense of perspective on the changes. At local level, I feel that Australia remains the lucky country.

The international financial crisis - return of the liquidity trap?

All those years ago when I did macro-economics for the first time, one thing that we learnt about was the Keynsian concept of the liquidity trap. This came about where no matter how much you lowered the interest rate or expanded the money supply (=liquidity), there was no impact on economic activity.

This came about because, among other things, plans to save were greater than plans to invest. In these circumstances, economic activity would contract no matter the expansion in liquidity. The only solution was fiscal policy, an expansion in real spend.

I think that this where we are now.

Postscript

I had no idea when I penned this simple post this morning just how right I appear to be. Listening to the news tonight - it is now 10.50 -the continuing financial meltdown is flowing straight across into the real economy. In Australia, consumer confidence is down 11 per cent.

In all this, there are rich pickings for some such as the Commonwealth Bank's acquisition of BankWest.

We managers need to be easier on ourselves

Much of my writing on management issues deals with the way that we as managers might improve our performance. Yet recently I have had cause to question whether this constant focus on performance improvement might not be wrong.

Don't misunderstand me. All managers have a professional responsibility to improve their skills and performance. It's just that I feel that we are in danger of setting absolute benchmarks, expectations, that cannot be delivered.

Our management skills vary. Further, all of us are better managers in some circumstances than another. None of us can be perfect.

My feeling is that we should stop agonising over the question as to whether we are a good manager or not. Instead, we should just focus on improving what we do.

Yes, this is still a focus performance improvement. But the emphasis is on relative improvement, not some focus on an absolute benchmark that none of us can meet.

We cannot aim to be perfect. We can only aim to improve what we actually do now.

The remarkable fall of the Australian dollar

After many years as a professional economist and strategic consultant, I know better than to try to predict the market. Still, both my wife (she is also an economist) and I blinked at the current decline in value of the Australian dollar as, and I quote, a "risky" currency.

Australia's economic fundamentals are some of the best in the world. Yes, local interest rates will fall, but so will they elsewhere.

Still, one should not complain. While the decline in the aussie will add to local inflationary pressures, it will also provide gains to exporters while discouraging imports. That's not a bad thing just at present.

The international curse of the ratings agencies

I know of no solution to this, but the ratings agencies have become something of an international curse.

As originally envisaged, their role was to aid transparency through the provision of information. Who could argue with this? The difficulty is that they have really become players in their own right, exercising authority without responsibility. The problem here lies in part with the agencies, more with those responding to them.

At Government level, the Australian state of NSW provides a current example. Maintenance of the state's triple A credit rating has apparently become the key policy driver. But to what purpose?

NSW faces a difficult budget position because of the current downturn in the State's economy. The state also needs a range of new infrastructure because of previous under-spending, driven in part by the perceived need to limit debt to retain the triple A rating. Further, the desire to limit debt has also driven the state into various forms of private-public partnerships, some of which have been fairly spectacular failures.

Just at present the NSW economy is in a slump. In the old days, this would have provided the opportunity to expand capital spending to catch up on the infrastructure back-log without adding to resource pressures. Not now.

Would it matter if NSW was slightly down-graded in credit terms? Not really.

Debt as a proportion of state GDP is low in historical terms. By global standards, NSW is a highly secure borrower. Given a shortage of Government debt in Australia at the present time (the Commonwealth itself has no net debt), I suspect that any NSW public loan raisings would be rushed. NSW simply does not need the rating agencies at this point.

At private level, the most significant problem is the way in which changes to ratings have become market players in their own right. Assume a sound company. A change in ratings can lead to loss of support that then affects company funding. In worst case, sound businesses may actually be forced down because of reduced capacity to fund activity.

In all, a bit of a mess!

Postscript

Winton Bates, an economist with long Government experience, had an interesting post on this one - Why did the rating agencies put their reputations at risk?

Why the US financial package should be rejected - and why Australia will ride out the storm

This post deals with two issues, one macro, one local.

Listening to the debate on the proposed US financial rescue package, I have slowly come to the conclusion that it should (at least from a US perspective) be rejected. I say this for one core reason.

The package mixes together two very different things. The first is the maintenance of liquidity so that financial institutions can lend to each other. This is a good thing. The second appears to be the maintenance of US property values. This is plain silly.

What will happen if the package is rejected? The worst case is that the US economy will slip deeper into recession as necessary corrections for past excesses work their way through. We have seen this before. The right economic answer would be to use monetary and fiscal policy to then expand the real economy.

What will happen if the policy is accepted? At best, it may ease the immediate pain, while leaving the US economy (and Government) saddled with still over-valued assets. The outcome will be slower longer term US economic growth.

Both Australian PM Rudd and Opposition Leader Turnbull are strong supporters of the rescue package. Both have the Australian, not the US interest, at heart. Both are, to my mind, wrong. We do not want a reduction in immediate local pain if the outcome is an enfeebled US.

Australia will survive current US problems. We do have significant structural problems, but they are far less than the US.

Our banking system is sound. Liquidity is a problem because of the flow-on effects of the impact of the sub-prime crisis on international bank lending. However, we also have a very large domestic deposit base. Non-bank lenders have been hardest hit by the collapse in liquidity because they do not have this deposit base. Hence the Government's actions to improve liquidity in this area. Overall, we are not going to see bank collapses even if the banks have to take major write-downs.

Our Government financial position is sound. Even NSW, Australia's basket case economy, has very low debt relative to Gross State Domestic Product. Our Federal Government has a present budget surplus and no debt. The Australian Government system has a whole has great capacity to use fiscal policy without mortgaging the future.

Our trade position is much weaker. However, and here Mr Keating (not one of my favourite people in normal circumstances) deserves credit, we have a floating exchange rate.

We can expect an export hit. Commodity prices will fall, although base demand will continue. Food prices may fall a little, but demand will continue. Service exports will decline. Here I am especially concerned about the education sector because we have built structures that in fact depend upon full fee paying students. If on worst case scenario we get a major decline in this area, all our major universities will need some form of bail-out.

While exports may decline, a floating exchange rate means that the external trade position will tend to adjust with time. We may see a fall in the value of the currency, although this is not certain. Should this happen, there will be flow-on inflationary effects. However, these can be managed.

In all this, both Government and Opposition have been spooked into a short term focus. In my view, now is the opportunity to adopt a longer term perspective. What should we do to build the domestic economy, including especially our infrastructure? What might we do, as we did during the Asian financial crisis, to help our Asian neighbours and trading partners adjust to the crisis?

Take China as an example. Chinese car sales are dropping in part because of price hikes on raw materials. Should the Government in conjunction with our resources sector be looking to lower China's raw material prices to encourage Chinese domestic demand?

I am not saying that we should. I am simply arguing that we need to think about our strength in a more turbulent world.

Management Perspectives - most popular posts 2

Continuing my irregular series on the most popular posts on this blog, the most popular posts among the last 100 visitors have been:

• The Balance of Payments, Australia and the sub-prime crisis. I did something of an update on this post in Saturday Morning Musings - longer term impact of the US financial crisis.
• The Importance of Demography and Demographic Change - update. I need to update this post to take into account later writings.
• Australia's new minimum wage - July 2008.
• Common Management Problems Series 1 - managing up
• The Dangers of Google's Market Dominance
• Alan Sarkissian - Audience of One
• Global Demographic Trends - A few macro numbers

The graphic shows from which countries visitors came. The US retains its number one position followed by Australia.

I don't try to write to attract specific country traffic, although I have been wondering if I should.

Just to explain why.

All bloggers like to be read. I am no exception. I have been wondering whether posts looking at links between countries might not be a useful addition to the blog.

I do know in terms of my own work that country inter-connections are becoming of increasing importance in a globalised world.

The fallacy of modern management

When I first began investing on the stock exchange, things were relatively simple. Select a small but balanced portfolio and then hold it for the long term.

So long as your firms were reasonably well managed, then you knew that continuing business improvement and reinvestment would lead to increased profits over time. In turn, this would translate to increased dividends, higher share prices, plus reasonably regular issues of bonus shares. Further, when your firms wanted new capital, you could either buy new shares or, alternatively, sell the rights for cash.

No more I fear. The failure rate among modern corporations is now so high that the only way to capture the compounding effect in a reasonably low risk fashion is by investing so as to follow the index.

Our current problems lie in a fundamental conflict between management styles and the underlying financial maths.

To illustrate, assume that the real economy is growing by 3 per cent per annum. In simple terms, this provides the growth umbrella across the economy as a whole. Now assume that firms as a whole set annual growth targets of 15-20 per cent.

Quite clearly, they cannot all achieve this. The more individual firms get to 15-20 per cent, the more other firms will have have to fall below 3 per cent to accommodate the faster growing firms.

It has always been the case that some firms are more succesful than others. That, after all, is the market. However, when all firms strive for very high growth targets the risk of failure inevitably increases.

Our problem today is that there is very little scope for conservative, rational management in a world dominated by high growth targets on one side, quarterly reporting requirements and the desire for quick profits on the other.

Assume, for the moment, that a firm thinks that 6 per cent real growth is a reasonable target. This is twice projected economic growth, but still within conservative bounds.

Over a ten year period, annual profits will grow from $100 to approximately $180 or by around 80 per cent. If dividends are set at 50 per cent of profits, then the dividend stream will increase from $50 to $90. On a constant PE ratio, share prices will also increase by 80 per cent. So over a ten year period you will get an 80 per cent increase in dividends plus 80 per cent capital appreciation. Plus, of course, the compound return on reinvested dividends. Not bad really.

The problem with modern management approaches is that it turns investment into a gamble on management's ability to achieve ambitious growth targets. The higher the aggregate growth targets, the greater the gamble because of the increase in the number of firms that must fail just on plain maths to deliver.