Can Australia afford its future?

There was a lot of concern during the crisis about Australia’s dependence on the inflow of foreign capital needed to fund its economy. There are really two separate elements to the issue: will we continue to depend on foreign capital and, if so, is there any risk of it being cut off?

Australia the capital magnet

Australia has imported capital for most of its history. Foreigners have seen it as a good place to invest. With the strong natural resource base, rapid population growth, an educated population and good institutions to protect investors, Australia has been a magnet for capital. The inflow has allowed us to invest more than we saved and that investment has boosted growth and generated the returns which allowed us to pay a good return to foreign investors.

While the underlying story is likely to be true into the future, there are many other countries likely to compete for that capital. Countries in Asia, Africa and South America look increasingly attractive. And with resource prices falling some of the capital which flowed into our resource sector will pull back.

That means we are likely to need less investment and less foreign capital over the next decade - which is probably good because it will become harder to attract.

Banks' funding* -  Domestic books, share of total

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* Adjusted for movements in foreign exchange rates ** Includes deposits and intragroup funding from non-residents Sources: APRA; RBA; Standard & Poor's

Savings are growing

Meanwhile, Australia’s domestic savings are tracking higher. Companies and individuals have all raised their savings, with compulsory superannuation playing a role in lifting the overall savings rate. Australia is already a high saving country; we just invest a lot more than most developed countries and that is what has made it necessary for us to import capital.

If we save more and invest less, we are unlikely to need as much foreign capital in the future. It is even possible that Australia could become a capital exporter. Already the value of equities we own outside Australia is greater than the value of equities foreigners own here.

In effect we will increasingly fund our own future.

Australia a capital exporter?

Immediately before the crisis we were importing a lot of capital with our banks being particularly dependent on offshore borrowing. When securitisation markets - a key market for banks to sell assets into in return for funding - effectively closed as a consequence of problems in the US, everyone was worried Australia’s access to other funding markets might also close. And when Ireland guaranteed all wholesale borrowings by its banks, the Australian government (like most others) had to offer the same guarantees to level the playing field and sustain conditions for banks to borrow.

So a silly decision by a foreign government could disrupt the market and suddenly stop the inflow.

We now know how to handle that. As long as the Australian government remains a reliable borrower (ie it keeps public debt under control) we always have the ability to guarantee borrowing by the private banks in an emergency.

That is the emergency response; what about a more gradual slowdown?

The role of the currency

The currency provides an important shock absorber. It works two ways.

As the Australian currency falls in value, the Australian banks have to borrow a smaller number of US dollars (or foreign currency in general) in order to maintain a particular level of lending in Australian dollars. So a fall in the currency means we need to borrow less. Coincidentally it also increases the value of collateral posted by the Australian banks which increases their ability to borrow.

And as the Australian currency falls in value, local assets become cheaper for foreigners to buy. Foreigners will then put more money into buying up local companies, local equities and other local assets. So while the banks might find it hard to borrow directly, foreign capital will find other ways to take advantage of the low AUD and flow into equity markets and through foreign direct investments.

The scars of capital shocks past

The sense of paranoia people have about a sudden stop in capital inflows has historical roots. When countries had fixed exchange rates it was not uncommon for crises to emerge when foreign capital inflow stopped. Without access to enough foreign currency, countries ran out of their reserves of US dollars, pounds, and yen and could not pay for imports of fuel and other necessities. The current problems in Europe have their roots in this problem: while the Euro is a floating currency as a whole, Greece cannot devalue relative to Germany.

But no advanced economy with a flexible exchange rate has suffered from a sudden stop.

We are also much less prone to funding problems than we were before the crisis. Slower growth has meant the banks have not had to borrow as much. More importantly, banks have diversified their funding sources and increased the duration of their borrowing. Part of this has seen them pay a lot more for local retail deposits. Bank management has done this as part of risk mitigation strategies but regulators and rating agencies have been pushing in the same direction.

So the big funding scare looks to be behind us. Australia may well be on the verge of a new era when offshore funding needs are not the major consideration – and indeed the challenge will be where best Australians should export capital.

Professor Rodney Maddock is adjunct professor in Economics at Monash University. He was formerly a senior executive at the Commonwealth Bank, chief economist for the Business Council of Australia and head of Economic Policy in the Victorian Cabinet Office. He wrote “The Future Demand and Supply of Finance” paper for the Australian Centre for Financial Studies Funding Australia’s Future project. He is currently working on a book on the Australian economy.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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