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Home > Performance > Quarterly update > Economic update

Economic and investment market update

A financial update from QIC

3rd quarter 2009

The global financial crisis (GFC), as its name indicates, has impacted every country’s economy, although the severity of the impact is varied.

Now, as we emerge from what appears to be the worst of the crisis, it is interesting to look at how different economies have fared.

Two of the most significant consequences of the GFC have been the mass deleveraging of the global financial sector and the collapse in world trade - the latter of these is largely the result of contracting household consumption of discretionary consumer goods. Both of these factors are important when determining the severity of the impact of the GFC to national economies.

Specifically, the damage done to each economy is proportional to:

1. The size of the economy’s financial sector relative to its gross domestic product (GDP). This is because the larger the economy’s financial sector, the greater the extent of financial market deleveraging (i.e. reducing the level of debt).
2. The economy’s dependence on foreign trade of discretionary consumption goods.

The countries of Western Europe, and in particular Iceland and Ireland, are most exposed to the financial sector due to their preference for debt (as opposed to sharemarket) finance and have been hit particularly hard. Asia has also suffered much more than expected due to its dependence on the export industry.

The US, on the other hand, has the smallest financial sector relative to GDP and is also least exposed to trade. This is because the US’s internal markets are so large that it does not depend on the rest of the world; rather, the rest of the world depends on the US consumer. So while it was over-leveraging in the US financial services sector that initiated the crisis, it appears the US economy will emerge relatively unscathed compared to other world economies.

The conundrum

However, the future is not all rosy for the US. One of the biggest problems facing the US government is how to deal with its high level of debt.

At present, US government debt is around $11 trillion. At 3% interest, this amounts to debt service payments of around $340 billion. However, with US government debt expected to increase to $20 trillion over the term of the Obama administration, it is possible that the US government may be liable for $620 billion in debt service payments, or 30% of its yearly budget. To make this situation worse, the extent of the government’s borrowing is expected to cause interest rates to rise beyond 3%, which would increase the debt burden.

While economic growth will ease the position, the US government has limited options in dealing with it. One option is to pay off the debt by increasing government revenue, which means higher taxes. Another option is to issue more government bonds, leading to a debt spiral (i.e. using debt to pay off more debt).

A third option is to monetise the debt, which involves the government issuing bonds that are then purchased by the Central Bank in the open market. However this is unlikely given the US Federal Reserve (Fed) has already issued large amounts of liquidity and the risk of inflation, such as that seen in the 1970s, rises.

Regardless of which option the US government chooses, inflation remains a looming issue. Since August 2007, the Fed has implemented a range of extraordinary policies in an attempt to reduce the severity of the GFC, which have increased the size of the Fed’s balance sheet and the US monetary base.

To date banks have hoarded the increased funds in excess reserves as deposits with the Fed, which has limited the increase to the money supply. However, as global economic activity improves and as the banks become more confident and begin to lend these funds out, this excess cash in the economy will lead to a sharp rise in the money supply. The possible consequence is an increase in inflation, unless the cash is removed from the system via tighter central bank monetary policy (i.e. higher interest rates).

What about Australia?

The Australian economy has proved to be robust and has continued to outperform most other advanced economies. Retail sales continue to hold, housing remains relatively strong, and our skilled vacancies are rising again.

Labour hoarding has helped limit the rise in our unemployment rate. Australian employers are still hurting from the skills shortage in 2008 and, rather than reducing the size of their workforce, have cut costs by reducing the number of hours each employee works and by taking on part-time employees.

However the unemployment rate is a lagging indicator, and while the current weakness in Australia’s capacity utilisation (i.e. the difference between our actual output and our potential for output) remains, we can expect the unemployment rate to rise further, even as the recovery begins.

As in the US we have also seen dramatic stimulus packages in response to the GFC, and we too face higher interest rates and inflation as a result of increased government debt and the excess cash currently being held by banks.
While the worst of the crisis appears to be over, only time will tell what the long-term impacts of the GFC on global economies will be. We are monitoring the economic environment closely, and continue to seek opportunities in the market to benefit the longer-term returns for QSuper members.

Doug McTaggart

QIC CEO

 

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