A curious data point

In the mid-1980s, the major sovereign debt rating agencies downgraded Australia’s credit rating in large part because of the large and growing level of net foreign debt.

Back then, net foreign debt was breaking above $100 billion for the first time, which was just over 30 percent of GDP. This was seen to be making the economy vulnerable to an external shock, especially if creditors suddenly demanded their money back, which would result in a currency crisis and skyrocketing interest rates.

Of course, there was no such problem given the reforms of the Hawke and Keating governments. Over the past 30 years, Australia has had only one major recession and that was 25 years ago when the rest of the industrialised world also slumped into a deep recession. It had nothing to do with foreign debt.

Fast-forward to today and the recent data shows that Australia’s foreign debt has hit a record high. At the end of September 2015, net foreign debt stood at $993.8 billion or some 61 percent of GDP. The release of what in years gone by would have been a shocking result did not get any coverage in the media, including the financial press. It had no impact on financial market trading and looks to have disappeared into the Australian Bureau of Statistics archives as a curious data point.

The question is, should it matter that net foreign debt is almost $1 trillion and over 60 percent of GDP?

The short answer is maybe.

One reason why it has slipped off the radars of markets and policy makers alike is the fact that the debt servicing costs are very well contained. This is because global interest rates are so staggering low. It is easy to make the interest payments, even with a high level of debt, with short-term global interest rates near zero and long-term bond yields generally near two percent. In other words, two percent on $1 trillion is easier to manage than five percent on $500 billion.

Where a problem may emerge with $1 trillion debt is if, or when, global interest rates materially rise. At the moment, there is very little chance of higher rates in the Eurozone and Japan, while any interest rate rises in the United States and the United Kingdom are likely to be moderate and slow to materialise. This is why there are few concerns. But a scenario where interest rates were to, say, rise to even half of pre-Global Financial Crisis levels, and there would be a substantial addition to Australia’s debt servicing burden and the net income deficit of the current account would widen sharply. If commodity prices stayed low or were to weaken further at this time, it would spell a major problem for the economy.

The other issue, which still lingers as a reason why foreign debt may yet turn into a problem, is a tightening of credit. This showed up during the 2008-10 Global Financial Crisis when borrowers restricted their lending and investors sold assets to build up their cash holdings. When financial and banking problems emerge, as they do every decade or so, banks, investors and many corporations simplify consolidate their investments and balance sheets causing pain for those with high debt levels.

Those low probability risks aside, the build up in foreign debt has helped to underpin Australia’s remarkable economic expansion. The capital in flows from debt have generally been used to fund investment, including housing, and have been an essential element in the 24 years of recession-free economic growth since 1991.

The end point of all of this is that the high and growing level of net foreign debt presents some risks for the economy, but they are not so large to cause any serious concern at the moment for policy makers or markets. But at the first hint that the servicing of that debt starts to challenge the Australian economy, most probably from a structural rise in interest rates, the issue could quickly move back into focus.

Stephen Koukoulas is Managing Director of Market Economics

thekouk.com.au
@TheKouk