Rudd's shock and awe approach should be welcomed

February 2, 2010

Dear Mayne Reporters,

Kevin Rudd held a remarkable half hour press conference starting at 4pm this afternoon when he announced a blanket government guarantee on the entire $600-700 billion in Australian deposits, plus a guarantee on all foreign debt issued by Australian banks in the international markets for the next three years.

The third leg of his shock and awe approach was doubling the government's investment in non-bank residential mortgages from $4 billion to $8 billion, which is too late for RAMS but important for the likes of Bank of Queensland and Aussie Home Loans.

Australia's move will put enormous pressure on the powerful countries meeting in Washington and Paris later today to do precisely the same thing when they resume Sunday crisis talks before world markets open tomorrow.

Whilst Australia's banking system is the strongest in the world in terms of profit, minimal bad debts, balance sheet strength and market capitalisations, there is a critical reliance on foreign debt to service that dangerously high $1 trillion in household debt.

And with the Australian dollar getting sold off like some latin American basket case, the estimated $120 billion bank refinancing challenge over the next 12 months would have been incredibly difficult in a credit constrained and confidence-sapped world.

We are a highly leveraged economy with strong banks and a strong federal government, but highly indebted households, a debt-addicted second tier of government and a corporate sector which has pockets of crazy gearing amongst infrastructure and property plays.

Starting with $620 billion in foreign debt and adding $1.2 billion a week to that through our $60 billion annual current account deficit is not a good position to be in during a global equities liquidation triggered by a global credit crisis.

The Australian dollar has been plunging as foreign investors dump offshore assets to shore up balance sheets at home. Whilst we all know the story of America's $US500 billion budget deficit and $US9 trillion public sector debt, you need to also comprehend the high end individual and institutional wealth accumulated by Uncle Sam's citizens.

The Americans have an estimated $US5 trillion invested in non-American equity markets and it is the repatriation of these funds which partly explains the seemingly bizarre surge in the US dollar after the embarrassing and destabilising collapse of its financial system.

The Rudd Government won't lose a cent from all of today's annoucements but they were still vital because the Australian Treasury and Reserve Bank doesn't have the balance sheet strength to directly take over a large amount of those $620 billion foreign debts or start bailing out and buying up private banks, which on Friday were still capitalised at almost $200 billion.

It was Ireland which started this game of unlimited guarantees on deposits and then Britain blazed the trail by guaranteeing future bank bond issues whilst baulking at a blanket guarantee on deposits.

Australia has now combined these measures plus added some government support for the non-bank mortgage market, so it will be very difficult for the major global powers to resist doing likewise.

Whilst the global financial system used to be based on trust determined by private share and bond prices along with things like credit ratings, the new benchmark in a government guaranteed world will be sovereign balance sheets and national credit ratings.

Rather than worrying about bailing out our banks, the Rudd Government will need to think about bailing out weak Asian neighbours and even formally guaranteeing the liabilities of NSW, which is adding $18 million a day to its $30 billion state debt at the moment.

Being the world's reserve currency, the US has the unique luxury of seemingly being able to print unlimited amounts of money. At least, this won't be a problem as long as the US dollar remains strong and that will almost certainly be the case for as long as Japan and China are prepared to keep buying US treasuries.

With more than $US1 trillion invested in US dollar denominated assets, the Chinese simply can't afford to turn around and punish the reckless Americans by cancelling the peg to the US dollar and instead declaring they'll only deal in euros going forward.

One other interesting question from today's announcement is whether it should be accompanied by more substantial cuts in official interest rates. Offering a government guaranteed 6% is arguably not fair when the rest of the world is offering much less.

If the Australian dollar surges back above US70c as some expect after this unlimited government guarantee, don't be surprised if the Reserve Bank comes through with another 100 basis point cut in the next couple of weeks.

However, if the dollar remains wallowing below US65c, it will demonstrate that the world doesn't think an Australian government guarantee is worth that much.

All up, I reckon the Rudd Government has done the right thing today. Global guarantees were coming anyway and it might just expedite the deliberations in Washington. History will show that this announcement was "a stitch in time" that will prevent any bank runs and help attract much-needed foreign capital to Australia to keep credit flowing through the economy.

However, such a dramatic step won't help overall business or consumer confidence in the short term as everyone is shell-shocked at what has happened.

Can you believe almost half of the discussion on Offsiders today was about the global financial crisis impact on sport? It won't just be CEOs who get blasted for excessive salaries. Stand by for movie stars and football legends to suffer a similar fate.

Even high profile stockbroker Marcus Padley was telling readers of The Age to go 100% cash over the weekend. Kevin Rudd made several references to what Australians are seeing on their television screens and any consumer of the media can only be incredibly fearful about the future.

I've put a few modest and heavily discounted buy orders on for tomorrow's share market trading, but the resolve is being severely tested at the moment.

That's all for now.

Do ya best, Stephen Mayne

* The Mayne Report is a multi-media governance website published by Stephen Mayne with occasional email editions. To unsubscribe from the emails click here.