Australia: The Sovereign Debt Debacle – Phase 2 of the GFC ?

Autumn 2010 Newsletter
Last Updated: 22 March 2010
Article by Martin Fowler

It is often said that the Global Financial Crisis (GFC) was caused by defaults on sub prime loans in the United States. Such defaults were merely symptoms of the underlying problem, rather than the cause, which of course was the over accumulation of debt by both businesses and consumers alike. Although investment markets have since seen significant appreciation since March 2009, it is now perhaps timely to review what, if any, improvements have really been made in the battle against the pernicious debt burden.

Household Debt in Australia

From an Australian perspective, household debt has only continued to increase, buoyed by a combination of first home buyers grants (now concluded), favourable domestic economic conditions and relatively low interest rates (now increasing). It is clear then that the Australian consumer has not really learned any lessons from the GFC and has not yet started to deleverage in any shape or form.

Australian Household and Government Debt as a percentage of GDP

In fact personal credit continues to grow, exacerbated by rising asset prices. House prices in Australia remain among the highest in the world. In the short term this trend appears unlikely to change as housing demand in major capital cities continues to exceed supply. Further, the labour market remains buoyant. Nevertheless, US housing prices before their housing collapse were far lower in relative terms but still fell heavily as the recession, and the subsequent hike in unemployment, led to mass foreclosures. Should Australia enter a deep recession at some stage later this decade then it is not implausible to suggest that a similar experience could unfold. A recession can lead to high unemployment which would face severe pressure on the ability of mortgage holders to continue to meet loan repayments. Under this scenario, it is perhaps inevitable that forced sellers would exceed demand and lead to moderate, to potentially heavy, price falls (depending on the extent of unemployment).

The consumer's inability to deleverage is in stark contrast to the corporate sector, which is much advanced courtesy of the enormous capital raisings and asset sales that transpired during the GFC. In this sense the corporate sector (outside the banking sector which continues to lend voraciously to over indebted consumers) has perhaps learned the lessons from the GFC. This is a positive for investors as the corporate sector is in better shape to weather another downturn should one arise.

Nevertheless, a large proportion of the corporate sector remains hostage to the frailties of the consumer. A large proportion of economic growth since 1960 has been driven by the increase in credit. Incomes dictate the degree of expenditure possible but, when combined with debt, expenditure (and therefore economic growth) can multiply. If household debt is reaching a crisis point then the ability to continue to fund further growth via debt is reaching a limit. At some stage consumers will have to reign in debt, which will reduce consumption and impact upon corporate profitability.

Real House Price Indices

Critics would perhaps argue that we have overblown the potential risks as housing prices and the domestic consumer emerged relatively unscathed from the GFC. The reality of course is that a disaster was averted in Australia by virtue of the rapid and synchronised global response to the GFC. The flood of liquidity helped lower interest rates (where banks otherwise would have been forced to ration credit causing a large hike in interest rates) and fiscal stimuli assisted upholding demand (preventing much higher unemployment). So, in the face of escalating household debt, household income actually improved due to the lower interest rates. Despite much higher mortgages, individuals were able to meet repayments.

Private Debt-Service Ratio and Interest Rates

Clearly though we are reaching a tipping point. The ability for individuals to service loans is now severely curtailed should interest rates rise even modestly (defaults are likely to rise significantly should home loan rates rise above 8%), let alone if unemployment rises. Yet the timing of the tipping point remains difficult to predict. Debt levels have been very high now for the best part of decade. It is possible for growth to continue against this backdrop while asset prices continue to rise and employment prospects remain sound. Yet the warning bell has been rung. A period of high unemployment and/or high interest rates is all that is needed to convert this warning to a harsh reality.

Private Sector Debt in the United States

At first glance, the chart below represents the parlous state of the United States economy, showing private sector debt to GDP approaching an astonishing 300%. Private sector includes both business and household debt.

USA Debt to GDP Ratio

We contend that this chart is somewhat misleading because household debt to GDP in the United States is around 100% of GDP (and decreasing, albeit slowly, as the US consumer has started to deleverage) and therefore the balance must be attributed predominantly to the business sector.

Australian versus US Household Debt-to-Gross Domestic Product Ratios

But here is the distinction. Outside the finance sector, we know that the average balance sheet in corporate America is in reasonable shape. We also understand that debt in the finance sector (investment banks, hedge funds, banks) roughly doubled between 2000 and 2007. So the majority of private debt can be attributed to the finance sector, large parts of which have already succumbed to the financial crisis (banks and hedge funds have failed and much of the toxic debt has been dealt with or written off). Once figures are adjusted for these failures then actual private sector debt may no longer look quite as daunting.

Sovereign Debt - Australia

So far we have focussed on private sector debt. Much has been reported about the huge amount of borrowing undertaken by the government to spend our way out of the GFC. While public debt in Australia has increased, it is unlikely to exceed 10% of GDP at its peak which means that the actual cost of servicing the debt is unlikely to exceed 1% of GDP. This is not only relatively low in a historical context but also very low in a global context.

Australian Government public debt (at 30 June)

This means that the Australian Government is on a strong position to be able to fund further initiatives should they be required in the event of another crisis.

Sovereign Debt - Global

Contrast this with the position in the United States and Europe where public debt levels are significant.

Net Public Debt - per cent of GDP

Public debt in the United States and Europe has exploded since the onset of the GFC due to massive stimulus packages and plummeting tax receipts. By bailing out the banking system and selected corporates, governments have simply shuffled the debt from the private sector to the public sector, creating new and arguably more hazardous policy challenges.

As of early 2010, US public debt to GDP has been estimated at 63% of GDP. If we assume an average interest cost on this debt (over the longer run) of roughly 4% per annum, then the annual cost of servicing this debt equates to 2.5% of GDP. On the face of it this does not sound too high. However, tax receipts only equate to around 15% of GDP which means that 17% of all tax receipts are effectively applied towards debt servicing. Compare this against the actual 2009 budget data where interest repayments on government debt equated to only 9% of all tax receipts due to the very low interest rate environment.

Sovereign debt problems are not a new phenomena. There have been some 87 defaults over the past 200 years. However, the number of countries experiencing financial difficulties (including Portugal, Italy, Ireland, Iceland, Greece, Spain and much of Eastern Europe; not to mention the United States and Japan) would suggest that a tipping point has been reached. The situation becomes much worse if we take into account unfunded liabilities (assets required to fund existing retirement, health care and education liabilities into the future) as shown below:

Official Net Debt, % GDP & Total net liabilities (on and off balance sheet) % GDP

The only sustainable way forward is for the public sector in much of the developed world to start to deleverage. Deleveraging will require a combination of the following:

  • reducing expenditure
  • increasing taxes
  • initiating reforms (such as user pays systems that transfer costs from the public sector to the private sector)

Such actions reduce private sector incomes and are politically unpopular. Further, such measures typically detract from economic growth and so, at least in the short run, reduce tax receipts making the task of reducing debt even more onerous. Yet the risk of inaction (defaulting) is greater so the countries concerned have little or no choice. The imbalances must be addressed if there is any hope of providing sustainable future growth

What is going to be the likely impact on financial markets?

It is clear that the much of the economic growth since the 1960's has been fuelled by the global debt boom. It also clear that the necessary deleveraging that needs to take place to provide sustainable future growth is, outside the corporate sector, not very advanced. Individuals and government alike have much work to do.

The risks for governments over this period are large and the prospect for enhanced social instability over these times is likely to be elevated. Further, the necessary reductions in government and consumer spending are likely to lead to below trend growth prospects over the coming decade. On balance, enhanced uncertainty as countries work their way through their financial problems is likely to generate greater volatility and the prospect of sub par growth is likely to result in more subdued returns. Under such circumstances the need for prudent stock selection (stocks with comparative advantages, high earnings certainty, strong cashflows and reasonable dividends) and asset allocation has perhaps never been so important.

Conclusions

To conclude:

  • Australian household debt levels are at unprecedented levels (not dissimilar to US household debt levels). While the US consumer has started to repair its balance sheet, the Australian consumer has not.
  • Having survived the GFC, the Australian and United States corporate sector (excluding the finance sector) balance sheets are in reasonable shape. "Public debt in Australia is low by global standards.
  • Public debt in the United States and much of Europe remains high. The policy challenges for these countries in coming years are immense.
  • Necessary reductions in government and consumer spending are likely to lead to below trend growth prospects over the coming decade. In turn, we would expect increased sharemarket volatility and more subdued shareholder returns.

For more information please do not hesitate to contact one of the members of our Wealth Management team.

This publication is issued by Moore Stephens Australia Pty Limited ACN 062 181 846 (Moore Stephens Australia) exclusively for the general information of clients and staff of Moore Stephens Australia and the clients and staff of all affiliated independent accounting firms (and their related service entities) licensed to operate under the name Moore Stephens within Australia (Australian Member). The material contained in this publication is in the nature of general comment and information only and is not advice. The material should not be relied upon. Moore Stephens Australia, any Australian Member, any related entity of those persons, or any of their officers employees or representatives, will not be liable for any loss or damage arising out of or in connection with the material contained in this publication. Copyright © 2009 Moore Stephens Australia Pty Limited. All rights reserved.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
Some comments from our readers…
“The articles are extremely timely and highly applicable”
“I often find critical information not available elsewhere”
“As in-house counsel, Mondaq’s service is of great value”

Related Topics
 
Related Articles
 
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions