Private investment and the current account deficit

Dr Justin Pyvis Dr Justin's picture

Another day, another "she'll be right" claim, this time aimed at the amount of investment in Australia (or lack thereof):

The claim that Australia is suffering an investment drought as mentioned by Michael Potter in today’s AFR does not stack up. We continue to run a current account deficit, hence a capital account surplus. Any worthwhile project can obtain finance. Many poor projects cannot and should not obtain finance.

At face value the statement is true. Australia borrows far more capital from overseas than it lends, hence the persistent capital account surplus. But the claim falls apart under a closer examination of the words "worthwhile project". An enormous amount of the foreign capital flowing into Australia is used to purchase durable consumer goods, also known as houses, as opposed to investment to expand the production of goods. Over 60% of capital flows into Australia go to just two sectors, mining (17%) and the financial system (44%). And to where do the banks send that capital? Housing.

aus-bubble-watch-bank-lending-sector.png#asset:6445

Sixty-two percent of bank lending to the private sector is channelled straight into housing, be it "investor" or "owner-occupier", up from fifty-three percent a decade ago. And it's not just the ratio that has climbed, with the total amount of housing debt up nearly 100% over the same period. Plenty of worthwhile projects indeed! They just have to be in mining or if you're Australian, housing.

The debate is then a question of whether or not those worthwhile projects are indeed worthwhile. There are legitimate economic and political factors involved, such as population growth and housing supply constraints, which would on their own see house prices and investment increase in those areas. But without "emergency low" interest rates for the better part of a decade and easy access to housing credit through the financial system's global wholesale connections, the misallocations would have been far less extreme. It is the combination of all of those factors that have driven the returns on housing investment through the roof (pun intended), with national prices up 80% from a decade ago and the two largest cities, Sydney and Melbourne, up 110% and 143% respectively.

The issue in our eyes is that not everyone was invited to the housing investment party and eventually it has to end. Home ownership for those aged under 40 has dropped from 36% in 2002 to 25% today, yet the amount of mortgage debt held by that group has doubled. That is exactly the kind of demographic time bomb that saw Brexit in the UK and Donald Trump elected in the US.

Then there is the issue of paying back all of the debt. Interest repayment rates are exceptionally low right now and banks are willing and able to increase borrowing limits year after year in line with asset prices. But eventually interest repayment rates will rise, those "worthwhile projects" will become "poor projects", foreigners will stop lending capital to the banks and the whole debt-fuelled housing industry will be in for some tough times.

Fortunately none of that will happen tomorrow so for now the "she'll be right" camp will continue to smugly espouse their brilliance, ignoring the risks that are right in front of them until the bust arrives. And when will it arrive? Our indicators are not predicting an imminent collapse and so investors shouldn't fret too much for the moment. But she most definitely will not be right and given that the current central bank-fuelled expansion has been running neigh-on a decade it won't be long now.