Cold, hard facts add to economic chill

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Two pieces of news from Australia on Tuesday were signs the economies there and in New Zealand are heading into much deeper difficulties, particularly in the crucial area of corporate indebtedness.

First, the Reserve Bank of Australia cut its cash rate by 0.75 percentage points. It did so to try to counteract the surprisingly quick deterioration in spending and activity. Some analysts are beginning to talk of Australia slipping into recession.

That is a concern in itself. But more disturbing was the decision of the trading banks not to pass on the reduction in the RBA's benchmark rate to borrowers. They said international credit conditions were still too difficult for them to access markets at cheap enough prices to pass on the interest cut. In other words, market conditions are blunting the stimulus that looser monetary policy should provide.

Commonwealth Bank, parent of ASB, was the one exception so far. It promised to pass on 0.58 of a percentage point. But if others fail to follow it could well slip back into the pack.

Again, those funding difficulties are concerns in themselves, suggesting the Australian banks and their New Zealand subsidiaries have little room to manoeuvre. Credit on both sides of the Tasman will remain tight and costly for the foreseeable future for households and corporates. This constraint will further chill economic activity.

But the second piece of Australian news on Tuesday suggests a much bigger problem developing for the banks there and here, one that reduces their desire to lend or cut interest rates.

It is the ugly issue of heavily indebted corporates on both sides of the Tasman. Last week two major Australian companies gave up on their debt difficulties. ABC Learning Centres, which manages nearly 1200 childcare centres in the two countries, called in administrators.

And the banks pulled the plug on Allco Finance Group, an investment house that almost succeeded in part-owning Qantas 18 months ago by way of a heavily leveraged buyout. Some very big names in Australian business are past or present directors, such as Bob Mansfield, a former chairman of Telstra, and Rod Eddington, a former CEO of Ansett and British Airways.

ABC owes eight lenders $A1 billion and Allco owes $A1.1b of which $A455m is local bank debt. CBA alone is expected to take a $A500m hit from ABC, plus a hefty loss on Allco loans.

Until the news broke, the banks had been saying they were committed to helping troubled companies work through their debt problems. But their decision to bail out of these two high profile cases was seen by many Australian analysts as a tipping point. With the economy slowing so fast and asset prices falling so rapidly, the banks now feel much greater pressure to bail out of problem companies.

The list of big defaulters is growing by the day. Some of Australian banks' biggest exposures to potential losses include those on Centro's $A3b on secured debt and $A1b of unsecured debt; Babcock & Brown Power's $A1b of secured debt; Babcock & Brown's $A700m; Opes Prime Group's $A650m; and Raptis Property Group's $A400m.

These are far from isolated cases. Australian companies have been piling on debt in recent years. In 2004, bank lending to them was growing at just over 5% a year. It then rose rapidly, peaking at a growth rate of 30% by the end of last year. It has since crashed back to virtually no growth, causing, in effect, a chronic credit contraction.

Heavy borrowing has dramatically pushed up Australian gearing ratios. The ratio for listed non-resource companies was 65% in 2004 but is now close to 100%, according the Reserve Bank of Australia's latest financial stability report. This brings the ratio close to the peak of 105% in 1990 at the start of Australia's previous corporate debt and banking crisis.

This is not to suggest Australia is about to experience another such crisis. The economy is far healthier and on average corporate borrowing is more responsible now compared to then. But the latest defaults are clearly only the tip of an iceberg, one that will soon puncture the complacency of Australian banks. So far they keep saying they will weather the global financial and economic crisis because they are so well capitalised, have such high credit ratings and such low loan loss provisions.

Yet, they are still having difficulties accessing international credit markets and their loan loss provisions are rising fast. Merrill Lynch said it expects the net write-off ratio across the banking sector to rise to 0.71% of assets in fiscal 2009 from 0.4% the previous year. While the low point of the measure was way down at 0.2% in the mid-2000s, the rise so far has taken the key ratio halfway towards the 1.5% at the peak of the early 1990s' crisis, one which devastated bank balance sheets.

Similar trends are apparent in New Zealand. Business debt almost doubled to $120b between 2000 and 2007. As a percentage of GDP it rose from 55% in mid-2003 to 73% at the end of last year.

Its not immediately clear why companies felt the need to borrow so much. They had enjoyed brisk profit growth until the recent slowdown (corporate tax collected by the government more than doubled to $11b in the decade to 2007); capital spending has shown good growth in some years but lacklustre levels the rest of the time; takeovers and mergers have not spiked; and there are few signs of other big expansions by businesses.

Whatever the reasons, corporate indebtedness is still short of the unsustainable levels seen in the late 1980s and early 1990s. Moreover, there are no large, high-profile businesses that are obviously unviable and irresponsibly run. This is a welcome contrast to the basket cases that emerged before and after the 1987 stockmarket crash.

Thus, New Zealand banks will be feeling more comfortable about their corporate loan portfolios today than they did in the early 1990s or their Australian parents felt then or now. But they have no grounds for complacency. The slowing global economy is hitting home. There will be a rising tide of corporate failures across the economy, not just in the property sector. Banks' loan losses will rise.

Three big issues will flow from this, two negative and one positive. First, New Zealand banks will seek to shore up their financial position. They will make less credit available and at higher prices; and second, their Australian parents will extract more profit to bolster their deteriorating financial performance, exacerbating the first effect.

But the third effect is positive. More Australian owners of New Zealand assets will hit the wall, as MFS has already done in financial services. This will give New Zealand investors the opportunity to buy back some assets, perhaps even the same ones they had sold to Australians at higher prices at the top of the market. Similarly, some local companies will fail, giving new owners the chance to rebuild them.

While corporate failures are always traumatic for the losers, they are often positive for the winners. They are a natural renewal process in the economic cycle. Last week's news from Australia, and the implications here, suggests we've reached such a turning point.

- © Fairfax NZ News