Lurking beneath Australia's AAA economy...

A recent article published in the Sydney Morning Herald suggests that Australians are talking about whether Australia will succumb to the financial crisis. Could it be that Australian voters are more in tune with Australia's economic realities than the country's pundits, and sense what lurks beneath Australia's AAA economy?

We hear a lot about government gross debt being in the order of $255.7 billion, but commentators seldom discuss another important figure, namely our gross foreign liabilities.

The official figures for Australia's gross foreign liabilities (public and private debt) stands at $2.224 trillion. Our gross foreign assets are $1.347 trillion which includes, ironically, the "reputable" asset derivatives.

We need to focus on the gross rather than net foreign liabilities here because it is unlikely that investors would repatriate into a falling market if the proverbial hits the fan.

Australia has had a current account deficit since the 1980s. That means we are spending more than we are earning. We've had to sell public assets to balance the current account deficit. Put simply, the surplus on the capital account is flogging off the sideboard to buy the fruit.

Our net international financial position is not strong and our gross foreign liabilities are alarming. Banks are the intermediaries between foreign lenders and Australia's big spenders. The banks have mediated the private household debt and as a result if there is a worldwide recession, banks could be called to pay up.

Our banks have borrowed short (internationally) and lent long (domestically, for mortgages etc.) which may explain why a US diplomatic cable dated 7 July 2009 published by WikiLeaks states, '…In late June, the IMF advised the Government to limit its borrowing in case it needs to bail out the major Australian banks, which must roll over short-term international debts which exceed A$500 billion…'

It may also explain why despite subsequent denials from the Australian Bankers' Association, economist Professor Ross Garnaut suggested in October 2009 that the big Australian banks were essentially insolvent at the time of the crash [in 2008] because "they were starting to have great difficulty in rolling over their huge external debt".

He added:

This time, the banks were in trouble with their debt, and the Government stood behind them. That's not a sustainable permanent thing because it would – now that it's happened once, there will be an expectation that it will happen whenever banks get into trouble, and you no longer have appropriate levels of responsibility about private decision making, if people think there's going to be a government bailout if they go wrong…..The consequence of private actors thinking they can take decisions and if those decisions turn out to be very profitable, they'll keep the gains, but if they go wrong, the community will pick up the losses. That's what moral hazard is, and the consequence of that is that you encourage risk-taking behaviour, you discourage prudence and I don't think that a sound financial system can work for long on that basis.

Given the soundness of Professor Garnaut's 2009 comments it is difficult to ignore his recent opinion that as the mining boom ends this will directly affect the Australian economy, average incomes, State and Federal government revenues and investment so much that we need to get cracking on "the other industries we're going to have to get the growth from".

We need specialised manufactures and non-resources tradeable industries for export, a reduction in the real exchange rate and import replacement to lower our current account deficit. All this requires an extensive increase in funding for university research and development combined with "productivity raising reform". But that doesn't appear to be our current trajectory.

Turning to derivatives, in November 2008 it was reported that the official Reserve Bank figures, from APRA, showed that Australian banks' off-balance sheet derivative exposures totalled $13.8 trillion (nearly ten times our Gross Domestic Product of 1.5 trillion USD, and probably understated). It was noted that 47.6% of the Big Four Banks' off balance sheet derivative exposure was to interest rate swaps ($8 trillion gross), with the remaining trillions in collateralised debt obligations (CDO), credit default swaps (CDS) and currency exposures.

According to reports, 'Banks could either deem derivative exposures to be "off-balance sheet" or use special-purpose entities to "house" the exposure in separate but related vehicles. In their absence, banks would be "forced" to increase the capital adequacy reserves required by prudential regulators.'

What remains a central issue is the fact that it was not made clear whether the Government's guarantee package extends to offshore borrowings by banks to cover off-balance sheet derivatives, bad bets and the impact such exposures would have if forced onto banks' balance sheets. Let's pray that Complexity Theory is flawed.

Since then we've learned that the National Australia Bank and Westpac borrowed money from the US Federal Reserve at the height of the financial crisis but we don't know if this has been paid back, whether it is included in our official gross foreign liabilities figures or the extent to which our gross foreign liabilities are written in Australian dollars; that Australia has a sub-prime debt market but we don't know the extent of it; that our banks say they have negligible (depends how you define it) direct exposures to the European sovereign debt crisis yet no one asks about their indirect exposure; that historical details of billions in government guaranteed loans have been taken off the Reserve Bank and Treasury websites, leaving us to speculate about whether or not this may be because the Government doesn't want Australians to know how much they've had to guarantee and/or they don't want the world to know the extent of the derivative exposures; and finally, despite Professor Garnaut's warnings, the Reserve Bank of Australia has set up a $380 billion bail-out fund called the Committed Liquidity Facility in the event that banks are insolvent or illiquid.

If the banks are hunky dory why is it necessary to set up a $380 billion emergency fund and, more importantly, is it enough in light of possible derivatives exposure?

Perhaps the Reserve Bank knows something that we don't?