There has been much talk this month about Australia’s over-reliance on the Chinese economy. With two-way trade at A$155 billion this is hardly surprising. Put in perspective trade with China is 2.5 times larger than our second largest trading partner (the U.S.) and greater than the sum of the 2nd, 3rd and 4th largest trading partners. It accounts for 23% of all Australia’s two-way trade.
Concerns are centred on China’s vast debt appetite which surpassed the three-times GDP threshold in the first quarter of this year. So why should this be of concern to Australia? Well, even if China’s is a managed economy it cannot control the economies of those with whom it relies on trade to support its economic growth.
What drives sovereign debt?
The borrowing of money by governments occurs for two key reasons to make up a limited shortfall in income over outgoings or to stoke productivity. It has traditionally been the latter that has driven China’s borrowings.
China’s overseas investments have also been strategic. Its purchase of US Treasury Bonds, for example, helped improve US liquidity to drive further consumption of Chinese goods. This is debtor finance of the highest order.
But with global debt at 217 trillion it has reached a staggering 327 percent of total global Gross Domestic Product and therefore it is rather a matter of when and not if central banks will have to remove their feet from the borrowing accelerator to the debt brake. And the threat of such austerity measures in countries that trade heavily with China will be a rapid reduction in demand for Chinese goods and a reduction in the income necessary to support its debt.
Of course China accounts for a vast amount of global debt. In fact half of all new global debt created since 2005 has been China’s, meanwhile it accounted for only 15% of the global economy during the same period.
It should then begin to become clear why global debt matters to us because when central banks take action to cool rising debt the first thing they will do is dampening their banks’ enthusiasm to lend by increasing capital reserves and tightening lending policies. We are seeing these pressures on Australian banks now. These strategies will lead to a credit crunch which in turn will lead to a reduction in demand. And this is where it hits China hardest. When (rather than if) China’s economy slows there will also be less demand for raw materials, which account for a vast percentage of Australian exports. China’s economic woes will be felt here quickly by a loss of exports and a loss of corresponding tax dollars which will have to be found elsewhere through austerity measures or tax increases.
There is also an elephant in the room regarding China’s rising debts and that is a maturity mismatch between investor-held bonds and China’s long term debt funded projects. There is also an economic disparity between local authority bond issues and Sovereign debt issues. China’s sovereign bonds should attract higher yields, but often times they do not. The mismatch in maturity cycles is the biggest concern because it means that China’s debt needs are not locked in for long enough to conclude the large infrastructure projects it has embarked on. If its economy suffers, investors will be free to liquidate leaving the State with unfunded projects. Only 23% of China’s bonds have maturity cycles that match its long-term debt demands.
As a harbinger of concern, Moodys recently downgraded China for the first time in 30 years which will undoubtedly increase its global cost of borrowing. This process will continue across the globe, most notably in Europe where failing economies such as Italy, Greece and Spain. And, while the growing middle class in China may take up some of the purchase energy required to keep the economic engine running in the short term, it cannot prevent a rather hard landing in the medium term. If we see a Chinese sell-off of US Bonds to fill the gaps in domestic funding left by exiting Chinese bond holders then we will know things are very bad.
The Unintentional Consequence of Regulatory Intervention
This is very much linked to our previous article.
We have born witness to considerable regulator pressure on Australian banks to reduce appetite for investor mortgages, aimed at dampening an overheated property market and to reduce exposure to the market. The unintentional consequence of this action is the negative affect it has on bank profitability. The profit banks make on interest-only loans amount to approximately 42 % on capital employed whereas Principal plus Interest Repayment loans account for a return on capital of only 17%. While investor loans may account for a small percentage of total lending, this shows how actions by regulators can have unseen consequences. And any weakening in shareholder returns can lead to a weakening of banks’ share prices which increases pressure on capital adequacy. The prime affect is a further retraction in lending appetite, favoring Tier 1, risks. In short – a further credit crunch.
Demise of the US Empire
Are we witnessing the demise of the great American Dynasty?
When you consider that the US Navy at the time of the Great War was equal to that of the Dutch Navy while Britain’s was twice the size of all other Navy’s of the World (excluding Germany’s) then it is easy to see how fast US international influence has grown in the last century.
Following the Great War the US suffered the ‘Great Depression’, which encouraged President Roosevelt to break from the Gold Standard and free the dollar to value against trade. This also allowed a freer production of money into the market to prime pump the economy (what we would later call ‘Quantitative Easing’). Since breaking from the gold standard, and printing paper money (something first introduced to the US by President Lincoln), it has held only a notional value. Paper money is nothing but a ‘Promissory Note’, carrying the promise to pay the bearer goods to its face value; a trading chit if you will, rather than an article of intrinsic value. With increasing sales of Treasury Bills by the US Government through the private banks, the true value of the Greenback must surely have declined in real terms.
Historically speaking war has proved very profitable for America. It funded German aircraft engines based on US designs in World War Two, and it operated a vastly profitable Lend-Lease program for Britain under which it lent money to Britain to fun US-manufactured war machinery which was then then leased back to Britain. This program was extended to Russia and turned out to be hugely profitable for America, seeing it enter a golden Age in the 1950’s. Meanwhile, in Britain, the costs of war debt saw it extend austerity (including rationing) into the 1950’s.
But even with a string of wars, America’s debt-driven economy has proved fiscally difficult to contain and every attempt to set a debt ceiling has failed. There are now concerns that new Debt Issues serve only to fund the interest on previous Treasury Bills – a downward debt-spiral. It was only immediately following the Global Financial Crisis (precipitated by the failing of sub-prime mortgage-filled Collateral Debt Obligations (CDO’s)) that levels of national debt declined briefly, before rising again in astronomical fashion (see graph below).
One factor that provides tangible value to the US Dollar, and causes demand for it, is the trading of oil and gas, because this is the currency in which these commodities have traditionally been traded. Oil importers are therefore forced to buy dollars to pay for fuel and, with fluctuations in oil prices and dollar values, are often left with billions of dollars which they invest in the US economy or hold in reserve. This artificially reinforces the value of the dollar.
Given the intrinsically notional value of the currency, any attack on its value is an attack on the economy as a whole. And this is why global oil and gas industries are of such importance to America. We are not given to conspiracy theories but if World markets moved away from trading oil and gas to (say) a basket of currencies or perhaps gold, this would have a devastating affect on the US economy.
Such actions would add credence to claims that US intervention in Libya was driven by Gaddafi’s plans to release North African countries from imperial influence by breaking away from trading oil in US Dollars (as suggested by the leaked Hillary Clinton emails). If true this would show how far the US is willing to go to preserve the importance of US Dollars to oil-trading nations. If Gaddafi had, as intelligence reports suggest, amassed 143 tons of gold and a similar amount in silver to support the launch of a pan-African Dinar it could have seen a reduction in demand for US Dollars for oil traded by North African economies that adopted Gaddafi’s currency. It would also have increased Gaddafi’s economic and political influence in OPEC.
Perhaps the importance of US Dollar oil trading explains America’s bipolar relationship with Saudi Arabia, to ensure a continuation of its currency – the Riyal – being pegged to it. Saudi Arabia is after all the World’s largest exporter of oil and holds considerable influence within OPEC and over other OPEC nations. In recent history three other countries have threatened to stop trading oil in US Dollars – Iraq, Syria and Russia. We know what happened in the first two and the US has recently taken steps to extend sanctions against Russia’s oil and gas industries.
It would seem to the casual observer that the US is following an unsustainable path of fiscal policy and, not to be too frivolous about this but, the decline of Rome has often been the studied benchmark for the demise of Empire and in this regard it is said that the first signs of the fall of Rome were “a decline in moral values and political capacity, an over-confident and over-extended military in foreign lands and fiscal irresponsibility”. I’ll leave readers to ponder any similarities…
Semper is concentrating for the next six months on two products:
Bridging Finance – property-secured loans for 1-8 months for any sensible purpose at 1% per month. 1st or 2nd mortgages or any sensible position in a stack of seniority for loan sums of $200,000 to $20,000,000.
Use of funds
- Pending DA land acquisition
- Development finance pending achievement of pre-sales
- Buy and sell bridge
- Exit from administration and asset sale
- Any other sensible proposal
Commercial Term Loans – property-secured facilities for 60 months renewable (with annual reviews) on an interest-only basis for sums up to $5,000,000 from 8.5% per annum.
A couple of recent Loans
Residual Stock – Brisbane
- Loan Sum: $1,800,000
- Security: 5 residential units| 1st Mortgage
- Rate: 12%
- Term: 8 mths
- LVR: 65%
This is a residual stock loan for a completed development in metro Brisbane. The developer failed to secure a satisfactory price for the remaining five units in the block and was seeking a bridging loan to buy additional sales time to achieve optimum profit.
Deleverage – Melbourne
- Loan Sum: $3m
- Security: Commercial warehouse and residential house | 1st Mortgage
- Rate: 16%
- Term: 6mths
- LVR: 67%
A small manufacturing business has experienced ongoing cash flow difficulties and was unable to meet bank covenants. It had been suggested (by their bank) that the warehouse be sold more than twelve months ago. Things did not improve and they did not listen. Semper paid the bank in full and have allowed the owners to sell their asset in a timely fashion without the embarrassing intervention of a forceful mortgagee.