After a period of remarkable stability where the All Ordinaries ranged between 4300 and 5000 points for almost two years, we are now decisively into a bear market after the biggest global sell down since 2009.

Resource stocks and financials led the decline as Wall Street tumbled 5% overnight. Indeed, Apple is now within reach of becoming the world’s most valuable company as its market capitalisation only fell 3.8% to $US350 billion last night, whilst Texan oil giant Exxon Mobil lost 5% to be worth $US359 billion.

The All Ords peaked at 5069.5 on April 11 and was at 4717 as recently as July 8. This morning it plunged 4.3% to a two-year low of 4170 at lunch time.

The latest wobbles have been triggered by governments in the major democracies slashing spending and raising taxes in an attempt to contain ballooning government debt after the global financial crisis frightened bond holders and exposed years of unsustainable budgeting.

Australia’s three great advantages in this situation are our relatively high official interest, the best ever terms of trade and gross federal government debt of only $195 billion.

Here is where official interest rates currently sit in the world’s 15 largest discrete monetary policy zones:

  • Japan: 0.1%
  • US: 0.25%
  • UK: 0.5%
  • Canada: 1%
  • Euro zone: 1.25%
  • Switzerland: 1.25%
  • South Korea 3.25%
  • China: 3.5% (up from low of 2.5% in November 2009)
  • Mexico: 4.5%
  • Australia: 4.75%
  • Turkey; 6.25%
  • Indonesia 6.75%
  • India: 8%
  • Russia: 8.5% (after five increases this year)
  • Brazil: 12.5% (8 increases this year after inflation hit a five year high)

Unlike most other countries, Australia has heaps of flexibility and all this bleating about the Reserve Bank at the moment ignores the fact that official interest rates were above 7% for more than half of 2008.

While Kevin Rudd was obsessed with fiscal stimulus during the GFC, a more effective tool is interest rates given Australians have debts of more than $1 trillion secured against their homes. Official interest rates were slashed from 7.25% in September 2008 to a low of 3% in April 2009, after the All Ords hit a low of 3091 points in March 2009.

Exactly the same sort of stimulus is open to the RBA now, and such a move would also provide enormous relief to those businesses which are being hammered by the high Australian dollar.

The biggest risk for Australia right now is a collapse in commodity prices after the RBA’s basket of commodities soared to be 20% above the pre-GFC peak. But that will only happen if economic activity in China crashes and the Chinese Communist Party is the world’s most liquid institution with $US1.3 trillion of US government bonds and overall foreign reserves of $US3.2 billion.

The Australian dollar generally moves with commodity prices, but also gets hit when investors become risk averse and retreat to holding US dollars or gold. This explains the US6c drop to US1.04 over the past week, including a US2c drop today.

The soaring Australian dollar has protected motorists from petrol prices topping $2 a litre and also triggered record offshore travel by Australians. It also makes us look bigger on the world stage. At $US1.10, the Australian economy was suddenly only 10 times smaller than the US, as opposed to 30 times back at the time of the Sydney Olympics when the local currency hit US49c.

Indeed, rather than Australians being unable to afford a stay in London, suddenly Eton was cheaper than Australia’s elite schools and Australian GDP in 2011 was headed for a result which was two-thirds the size of Britain’s economy even though the mother country has three times as many people.

While GDP measured in US dollars is the most common yardstick of economic strength, gross sovereign debt is increasingly on the radar of investors. Here is how some of the big boys rank on federal government debt:

  • US: $14.3 trillion (with political approval to go to $US16 trillion)
  • Japan: $US10 trillion
  • Germany: $US2.9 trillion
  • Italy: $US2.5 trillion
  • UK: $US1.7 trillion
  • Greece: $US450 billion

Contrast those figures with a country like Norway which has negligible debt and the world’s third-biggest sovereign wealth fund worth $US750 billion, courtesy of its budget surpluses which peaked at almost 30% of GDP as it saved North Sea oil profits.

The figures can be misleading because sovereign debt should consolidate all tiers of government. For instance, Chinese local governments are estimated to have $US2 trillion in debt. This is very different to Victoria’s 79 local councils which have assets of more than $60 billion, combined debts of less than $500 million and fully-funded public service super.

The biggest problem over the past few years has been banks and governments in western democracies borrowing far too much money so that private citizens and businesses could consume and invest beyond their means.

The expectations of their citizens will have to be scaled back, which is an enormous challenge given the demands of ageing baby boomers.

It won’t be easy, but the Greeks will have to get used to lower pensions and wealthy Americans and companies will ultimately have to pay higher rates of tax.

Peter Fray

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