Introduction and study objective
This study focuses on estimating the probabilities of at least one systemic crisis in the Australian economy by 2040. By ‘systemic crisis’ is not meant a recession where GDP may fall a few percentage points. It is a crisis which is triggered by an exchange rate crisis (that is, a rapid fall in the currency) that undermines confidence of foreign and domestic investors to the extent that net outflow of capital from a country is significantly greater than foreign reserves available at plausible interest rate settings. This forces the country to:
- default on its international obligations or, at the very least, mandate the timing of the repayment of international obligations; and
- in this context, negotiate large loans from the IMF or other international agencies or countries.
If the banking sector has been active in being a transmission mechanism for foreign loans, then the exchange rate/balance of payments crisis will be associated with a banking crisis and a severe contraction in the availability of credit and public sector bail-out of one or more major banks.
Once a crisis is triggered the peak to trough fall in GDP can be between 20 and 30 per cent, as has been recently experienced by the Greek economy. Indeed, since 1970 there have been approximately 60 crisis of the type described above, some of which have occurred multiple times in the same country, such as Argentina.
These types of crisis are designated as systemic because once they occur the future direction of the economy, both in the short and longer terms, is fundamentally changed from what would have been the case if the trends before the crisis had been maintained. For example, for many years after the crisis, other than major loans from the IMF or supporting foreign governments, no major new sources of foreign capital may be available. The country’s level of economic activity will be totally determined by the exporting and importing replacement capacity of the country.
In short, a systemic risk associated with an outcome is one which if the outcome does occur is likely to be associated with:
- a significant decline in a peak to trough GDP profile up to 25 per cent of GDP or more;
- a lengthy period of three to eight years before the previous GDP peak is regained; and
- forces structural change that fundamentally can alter the economic structure and policy content of a country and when growth is resumed it is likely to be below the trend rate of growth that was experienced before the crises. There is likely to be a “lost generation” of jobless.
– Systemic crisis potential: Why Australia?
Although a systemic crisis has not happened in Australia that does not mean that it won’t if the appropriate economic fundamentals are established that have the risk of facilitating crisis. Key indicators that are important in predicting a crisis are a country’s foreign gross and net debt to GDP ratio, gross and net foreign obligations ratio (equity plus debt, foreign capital), and current account deficit as a per cent of GDP. Australia currently has ratios for these variables which are near or greater than the ratios for many countries which have experienced systemic crises in the past. More worrying is the fact that the current Australian exchange rate is significantly over-valued compared to the purchasing power parity (PPP) rate, or the rate that equalises costs between Australia and the United States. Currently the PPP rate is a little below 70 cents to the $US. A significant exchange rate correction is expected over the medium term in response to Australia’s terms of trade returning to more normal levels with this devaluation of the currency which having an adverse impact on the crisis’ prediction indicators. That is all else unchanged an exchange rate devaluation will increase the gross foreign debt to GDP ratio along with the current account deficit in accordance with the so-called J curve effect.
On this basis an assessment of the probability of Australia experiencing a systemic crisis over the next one to two decades is not only justified, but required.
– Australia: The systemic risk assessed
Systemic risks are those risks which, if they do occur, have the capacity to trigger an economic crisis. The systemic risks assessed in this study are:
- terms of trade shock triggered by a variety of causes, including environmental threats to Australia’s exports;
- global financial instability of the type that preceded the Great Financial Crisis (GFC) of 2008; and
- carbon emission penalties.
Currently, Australian terms of trade are high compared to the historical average. There are a range of factors which could drive the terms of trade back towards the historical average with the consequence of a large scale devaluation of the Australian currency.
In terms of financial instability, since the withdrawal of fiscal stimulus over 2011 and 2012, reliance has been placed on unconventional expansionary monetary policies under the designation ‘quantitative easing’ which involves constant injections of crash liquidity into the economy with expansion of Central Bank balance sheets. This policy has been particularly pursued in the United States and Japan. This has increased substantially the capital inflows into emerging economies which has the capacity to trigger systemic crises in a number of large emerging economies if the capital immediately flows out again with the ending of quantitative easing policies. The ending of qualitative easing will increase interest rates in developed countries in general and the United States in particular.
Finally Australia has one of the highest CO2 per capita emissions levels in the world. There is a risk that if realised costs of climate change continue to increase that a carbon price penalty will be imposed on Australia, irrespective of Australia’s consent in the matter.
– The research methodology
The research methodology for this paper consists of:
- develop a systemic crisis predictive model to estimate Australia’s historical and forecast probability of a crisis;
- in conjunction with the crisis predictive model and straightforward macroeconomic framework for the Australian economy, estimate the impact of the three systemic risk factors listed above in terms of increasing the probability of a systemic crisis and the probability of at least one crisis occurring over the period to 2040.
Step (ii) is undertaken with the construct of a base line projection for the Australian economy to 2040.
The methodology is based on the fact that in order to create a useful framework to analyse the concept of systemic risks many of the drivers must be quantified in terms of probabilities. Probabilities are the only way to feasibly quantify outcomes for drivers and transmission mechanisms which involve a great deal of uncertainty in terms of future possibilities.