Pressure on Australia's Current Account Deficit?

UNCLAS SECTION 01 OF 02 CANBERRA 001252 SENSITIVE SIPDIS STATE FOR EAP/ANP TAGS: EFIN ETRD ECON AS SUBJECT: Pressure on Australia's Current Account Deficit? REF: CANBERRA 1121 ¶1. (SBU) Summary. Australia's current account deficit (CAD) fell sharply to its lowest level in six years from almost A$20 billion in the March quarter (7 per cent of GDP) to A$9.8 billion in the June quarter (3.2 per cent of GDP) due to a boost to export prices (especially coal and iron ore) and a decline in demand for imports. Nevertheless, there could be significant difficulties ahead in financing the CAD because of the contraction in international liquidity. End summary. PROSPECTS FOR THE CURRENT ACCOUNT DEFICIT ¶2. (SBU) Australian Bureau of Statistics data showed that Australia's current account deficit in the September quarter fell to A$9.7 billion, half the peak reached in the March quarter, due to better export performance based on large increases in prices, not volume. Coal prices were 44 per cent higher while the volume of shipments was 2 per cent higher. Iron ore exports rose by 1 per cent in volume but 12 per cent in price. The Treasury's Mid-year Economic Update (ref A) had forecast Australia's current account deficit would narrow to 4.5 per cent of GDP in 2008-09, lower than the 5 per cent of GDP forecast at Budget in May 2008. ¶3. (SBU) Australia has traditionally run a deficit on the current account because of a persistent trade deficit and net income transfers to service foreign debt (up seven per cent in the June quarter to A$658 billion). Despite the September quarter improvement, its position is now looking more vulnerable, due to the large net income deficit and the abrupt end of the resources boom. After significant increases in US dollar contract prices for iron ore (up around 85 per cent) and coal (up between 125 and 240 per cent) earlier this year, commodity prices have now severely deteriorated with falls in spot prices to around US$50/tonne compared to US$120 under contracts. The contract prices remain in force until March 31, somewhat reducing the immediate impact of the changes in the spot price. However, steel producers are reportedly trying to delay shipments of iron ore and coking coal based on declining production. ¶4. (SBU) Analysts are pessimistic about the trade and CAD outlook. A Commonwealth Bank senior economist said: "Looking ahead, any substantive and sustained current account improvements will remain elusive, mainly because any future trade account improvements due to easing capacity constraints and consequent rising export volumes will likely be eclipsed by the ongoing large net income deficit." Westpac's chief currency strategist said the income deficit rivaled only Iceland's and New Zealand's as a share of the total current account deficit and he cited signs of stress in funding the deficit. ¶5. (SBU) Australia has one of the world's largest current account deficits in absolute terms, financed almost wholly through the overseas borrowings of Australia's four major banks. Currently, Australian banks have to roll over about A$75 billion in short-term foreign debt every month and raise a net A$5 billion in new foreign funds. Growing difficulty in rolling over medium-term debt will increase the banks' dependence on short-term funds. However, even short-term funds are in shorter supply and the Japanese financing of Australian-dollar-denominated securities (the carry trade) has virtually and abruptly ended over the past five months. ¶6. (SBU) Australia's Big Four banks are highly rated internationally Q6. (SBU) Australia's Big Four banks are highly rated internationally and have relatively little exposure to sub-prime mortgages, which represent less than one percent of all Australian mortgages compared to over 15 per cent in the US. However, their ability to finance the CAD is constrained by a reliance on 'wholesale funding' or borrowing from domestic or overseas wholesale money markets. Recently, Standard and Poor's said that Australia's AAA international credit rating is under pressure from the slowing economy, deteriorating fiscal position, contingent liabilities of the bank guarantee and the large current account deficit; S&P is reviewing the rating but has not assigned a "negative" outlook to it. ¶7. (U) Corporate finance in Australia is similarly affected by liquidity constraints. Westpac Bank recently warned that US and European banks operating in the region are retreating to their home markets and Australian banks do not have the capacity to supplement this loss of finance. According to Bloomberg data, about 60 per cent of the syndicated loans written in Australia over the past two years were provided by about 170 foreign banks and about A$70 billion of syndicated facilities are required to refinanced over the next 2 years. Merrill Lynch reports that about 20 key foreign banks (responsible for (A$54 billion in corporate financing) in Australia CANBERRA 00001252 002 OF 002 are rationing credit. ¶8. (SBU) Comment: It is unlikely that the September quarter improvement in Australia's CAD can be sustained given falling commodity prices and lower world demand. However, falling import demand is likely to keep the CAD from climbing back to historical highs. The contraction in international liquidity is a serious challenge. It is unclear whether even Australia's highly rated banks can continue their reliance on 'wholesale funding' or borrowing from domestic or overseas wholesale money markets in the current financial climate. In 2007, the Reserve Bank intervened briefly to finance the CAD during the onset of the sub-prime liquidity crisis, but that was only a short-term solution. An alternative strategy could be the expansion of Australia's official debt market funded by foreign investment. End comment. MCCALLUM