PORTFOLIO POINT: Australia’s banks won’t have trouble raising cash, so investors should be confident their capacity to pay yield won’t be affected.
Readers are right to feel a little anxious over our banks right now. A number of brokers have, over the last week, suggested they are expensive – and indeed NAB intensified concerns by lifting provisions for bad and doubtful debt.
That being the case, I don’t share this growing unease. Firstly, we’re at the bottom of the credit cycle (see my article of July 2, Why it’s time to ride the cycle) and I still maintain there is plenty of earnings upside over the next 12-18 months. Much of this has to do with the fact that property is set for a rebound (see Louis Christopher’s It’s on! The house price recovery is underway, and Property heats up, as well as my 8 October piece, A property upturn has legs). Moreover, banks go into this upswing with higher net interest margins than in the recent past. That is, for each loan they write, they’re earning more now, relative to what they borrow, than what they were prior to the GFC.
The only resistance I’ve really seen to this view stems from the assertion that our banks are too reliant on external funding. This, accordingly, has two deleterious effects. One is that it will place a cap on how far banks can expand their balance sheets (into what would otherwise be a solid property rebound) given that foreigners will be increasingly reluctant to provide funds. The second is that this reliance will restrict the ability of banks to pay yield, as they accelerate a move into higher cost domestically sourced funding (largely to shore up balance sheet stability).
Readers may remember a great piece Alan Kohler wrote discussing some of these issues – citing research produced by Variant Perception. In it, they suggested Australia’s net external debt resembled that of the European periphery and argued that our banks would have trouble funding themselves. Recall that the market’s aversion to Spain’s sovereign debt stemmed from the large debts carried by their banks and not necessarily from the public debt burden. The argument is we are in the same position, and in fact David Murray (ex CBA CEO and chairman of the Future Fund) more recently echoed some of these views, although his point varied in that he was more concerned about public debt and the external balance. But, as the European crisis has shown us, the issues are inseparable.
Fortunately for investors, I don’t think these concerns are quite accurate. Thus the resistance to my view is easily overcome. There are two reasons.
The first reason is that Australia’s banks don’t actually rely heavily on offshore funding. That’s not to say foreigners are insignificant, they are not. However, neither do they threaten the system and we are not beholden to them by any means.
This is illustrated in Figure 1. The first chart shows that over 50% of bank funding comes from domestic deposits alone, while 40% comes from short and long-term debt (or wholesale markets). Now it’s true to say that foreign investors are big players in the wholesale markets, taking about half of short-term bank debt and around 66%-75% of longer-term debt. However the second chart adds some perspective to this by showing that overall, foreign demand for long-term bank debt accounts for around 10% of the banking sector’s total funding needs, while it’s a bit over that for short-term debt. Throw in foreign equity (around 30% of total bank equity, which then accounts for 10% of bank funding) and you get something like 25% of bank funding provided by foreign investors. Not insignificant, but when 75% of funding is provided domestically, it isn’t a heavy reliance.
The second reason is that it is highly unlikely foreign investors will become wary of providing funds. This 25% is not a fickle funding source and is unlikely to become one even during another credit crisis. There are two related reasons for this.
- The Australian government can guarantee, as it did during the GFC, debt issued by Australia’s banks;
- It can do this credibly, because Australia’s overall external position isn’t that bad and its sustainability cannot be seriously questioned.
Think back to Australia’s experience in the wake of the GFC. The government simply guaranteed the debt of Australia’s banks – gave the option at least for issuers – and this proved highly effective.
Indeed the RBA notes that during the financial crisis, investor demand for bank debt remained strong, exactly because of “the guarantee by the Australian government and strong investor appetite for highly rated debt.” It did note a modest and temporary drop-off in foreign investor demand, but this was offset by increased domestic demand. In particular, domestic banks themselves provided a strong offset, increasing their share of new bonds on issue from 5% to about 15% in late 2009. That said, foreign investors were still the bulk of the investor base.
What this shows is that the government’s backstop was credible – investors had faith in it. This is the key difference between Australia and countries like Italy and Spain – or even Greece. Investors didn’t/don’t have faith that those governments could provide an effective backstop (for whatever reasons rightly or wrongly – wrongly I believe).
Our stronger fiscal position is a big part of the discrepancy– modest public deficits and public debt. But greater investor confidence also reflects our external position – measured by our net foreign debt (total for the nation public and private) and current account deficit – which is nowhere near as unstable or unsustainable as some (eg Variant Perception, David Murray even) would have you believe. Consequently, the country (again, rightly or wrongly) is in a strong position to back our banks (if needed) without too much risk to overall economic stability and growth.
To see this, let’s first consider the current account deficit. Just as a refresher, the current account forms part of our balance of payments. This records Australia’s transactions with other countries – exports, imports, borrowing, lending, income and investment flows etc.
It’s true to say that we’ve run a current account deficit basically since records began, and the reason why some argue this isn’t healthy is because deficits need to be financed by borrowing money overseas – which increases our net foreign debt etc.
Now, as you can see in Chart 1, the current account deficit, at about 3.5% of GDP, has improved markedly from the rates we were experiencing prior to the GFC. That being the case, there are two reasons why people remain concerned.
Firstly, many people question why it is that we are still running a current account deficit during a mining boom. That is, still borrowing money from foreigners during the boom (David Murray alluded to this). The argument goes that if we can’t get into a surplus position during a commodities boom, we never will.
More to the point, and secondly, is it argued the deficit will balloon as the commodity boom unwinds. If that happens then we’ll we need to borrow more, the net debt will rise further, and so forth and so on. People like David Murray and Variant Perception suggest investors may soon tire of this, just as they got tired of funding Greece, Spain and Italy.
I don’t think this will happen though. Have a look at chart 2.
The chart shows that flows of income to overseas investors are the biggest part of our external deficit – 83% of it over the last 10 years. The trade balance is only small, on average about 17%, although it fair to say this is volatile as you can see in chart 3 and this volatility does drive swings in the current account deficit – presumably that’s why there is so much emphasis on the trade balance.
However this focus confuses the fact the persistence of the current account is due to the net income component. The reason why this matters, why it’s critical even, is because the biggest chunk of those net income flows (over time) are dividend payments – not interest rate payments as many think. From a foreign investor’s perspective, if half your external balance is made of discretionary private-sector dividend payments, then what’s the worry. Take out those payments and the current account deficit shrinks to a little over 1% of GDP – and that’s with a sizeable trade deficit. Indeed as Chart 3 shows, the nation’s debt servicing burden (interest rate payments) is low – and constant – at around the 1-2% mark.
All of the above suggests to me that our banks are not going to have any problems raising cash from abroad. As a result, I don’t think investors should be concerned about the relative attractiveness of Australia’s banks nor their capacity to pay yield.