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