FOREIGN DEBT: by Ken FrancisNews Weekly
Greenspan issues warning over foreign debt
, December 17, 2005
Alan Greenspan, the retiring chairman of the US Federal Reserve Bank, has warned that the consequences of the growing US trade deficit could be "quite painful" if it is not arrested. His warning could equally apply to Australia, writes Ken Francis.There is an old saying that if you took all the economists in the world and laid them end-to-end, you would never reach a conclusion.
This adage has never been proved to be more true than in the current debate in the financial press about the implications of the large trade deficit being run by Australia and the United States.
Governments and lay observers are faced with the choice between two strongly-held positions: On one side, it is argued that large trade deficits do not matter; on the other, that it is a serious matter.
Each politician, business person, investor, superannuant or home-owner will need to make up their mind on this important question, as the answer they take to be correct will affect not only the higher levels of public policy, but is at the heart of all investment decisions, large and small.Trade deficit optimists
The trade-deficit optimists - who are unconcerned by the current levels of Australia's foreign debt - have made their case in recent issues of the Australian Financial Review
Treasury economists David Gruen and Amanda Sayegh (AFR
, November 15. 2005) argue that there were "scant signs" that, even with a current account deficit of 6.7 per cent of gross domestic product (GDP) and net foreign liabilities of just over 60 per cent of GDP, Australia would be increasingly vulnerable to external shocks.
Their argument was supported by the view that "capital markets have thus far treated the build-up of foreign liabilities in industrial countries very differently than in developing countries".
The capacity to borrow in their own currencies and ability to hedge any foreign-currency risk, was the source of stability of industrial economies compared to developing countries. Gruen and Sayegh observed that if Australia sought to stabilise foreign liabilities at current levels it would need to run a trade surplus of 0.5 to 0.75 per cent of GDP. They did not believe that this latter task would be "too onerous".
Further support for the optimist position was advanced by Richard Scheelings and Daniel Mulino from Monash University in their article "Foreign debt - it's not a problem" (AFR
, December 5, 2005).
They scoff at those commentators who disagree with them as engaging in "policy hysteria" and being engaged in "the re-run of an old movie that was scarcely entertaining in its first run".
The Scheelings and Mulino case is based on the following propositions:First
, Australia has had a substantial current account deficit (and a corresponding capital account surplus) for most of the last 50 years, yet its economy has been successful and productive in per capita
terms for that period.Second
, "a policy aimed at achieving a perpetual trade balance would rule out the gains" from capital flows between developed nations that were net savers and those requiring investment.Third
, that while Australia's net foreign debt has grown from $96 billion in 1989 to nearly $430 billion in 2005, these nominal figures are misleading. The two economists believe that the net foreign debt should be expressed as a proportion of GDP, in which case the rise has been "more modest" in that it has grown over the same period from 30 per cent to 50 per cent of GDP.Fourth
, the fact that Australia's indebtedness is mainly private rather than held by government provides consolation for us, they say. Again, our fortunate position as a developed country with a floating exchange rate will protect us against the economic instability and high costs of borrowing that would face the government of a developing country that defaults on a loan. In respect of an Australian-based borrower who fails to repay a foreign bank, the authors believe that the fallout will largely limited to their relationship. "The rest of us will be no more affected than if the Australian-based borrower had defaulted on a loan to an Australian bank".Trade deficit sceptics
In contrast, there is the school of trade deficit sceptics, mainly based in the US, who are rather more concerned about the instability in the world economy that might follow from uncontrolled trade deficits.
Alan Greenspan, the retiring chairman of the US Federal Reserve, declared (AFR
, December 5, 2005) that the consequences of the growing US trade deficit could be "quite painful" for the world economy if it was not arrested. His warning could equally apply to Australia.
While discussing trade deficits in London, he said, "We do not as yet have a firm grasp of the implications of cross-border financial imbalances".
He went on to state that deficits that accumulate to "ever-increasing net external debt ... cannot persist indefinitely".
Greenspan, and his successor Ben Bernanke (AFR
, November 24, 2005), addressed the question of how long foreign investors would continue to pour funds into the US in the light of record high trade deficits.
The two bankers doubted that foreign investors would unload their holdings; but, in the event that it did occur, prices of US stocks and bonds could plunge, interest rates would rise and a financial crisis would develop.
Should huge trade deficits persist, Greenspan believes that investors could baulk at further financing and lose their appetite for US assets. In the meanwhile, a flood of private funds continues into the US with $US113.8 billion net of assets purchased in September.
Another trade-deficit sceptic is Stephen Roach from Morgan Stanley bank (AFR
, November 3, 2005), who called for a wake-up call for the US economy in the light of the current account deficit at 6.5 per cent of GDP.
He sees the possibility that US consumption could decline, with severe consequences for China. The resulting build-up of inventory and the inevitable production adjustment could have serious ramifications for Australia and other countries as demand for energy and commodities declined.
It is difficult to understand the complacency of the Australian Government towards our economy's levels of overseas indebtedness.
While the worst may not happen, there are risk factors operating in the global economy that should be assessed while there is time to take remedial action.Global factors
Among the global factors that could exacerbate Australia's foreign indebtedness are:
- the global oil supply and the potential for severe price rises;
- the consequent impact of oil price rises on our inflation rate and the possibility of a slowdown in economic growth;
- a correction (i.e. collapse) in the US and Australian house price bubbles which have tempted people to borrow money for consumption as if there were no tomorrow; and
- interest rate increases and inflationary pressures.
Further risk factors operating particularly in the Australian context include:
- the level of competition which our agricultural and mining exports can soon expect to encounter from Brazil, Argentina and Russia;
- the poor performance of our export industries over the last five years and the general decline of the local manufacturing sector over the last 20 years.
Should interest rate increases or emerging unemployment create widespread default or bankruptcy amongst small business owners or homeowners, then we will find that any adverse impact on the Australian banking system will be mitigated by support from taxpayers, irrespective of the fact that the funds lent to housing and business are "private" borrowings, and not "public".
Like Greenspan, it is impossible to predict the manner in which any adverse scenario might unfold, but there is no doubt that there is potential for any financial or economic crisis in a single developed country to spread throughout the world.