Recent headlines:

Effects of retreating foreign banks in Australia

Posted by cij on Nov 24th, 2008

Recently, we found this news report in the mainstream media:

A significant retreat of foreign banks from the Australian corporate lending market is under way, which will leave the “Big Four” domestic institutions scrambling to pick up the slack in a mass refinancing of company debt due to happen over the next 12 months.

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According to research compiled by banking analysts at Merrill Lynch, the total debt raised by Australian companies since 2006 stands at $285 billion. Merrill estimates that as much as $54 billion of that amount is held by what it describes as “retreating” offshore banks.

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“This dislocation represents a potential benefit for major banks to refinance and upsize to good customers at vastly improved margins. However, it also raises the likelihood of potential bad debts collapsing sooner and a need for capital.”

As we mentioned before in Can falling interest rates and rising mortgage rate come together?,

In other words, there are not enough domestic deposits to fund all the needed credit (e.g. home loans) in this country.

Australia is dependent on foreigners for credit because of its lack of domestic savings. The retreat of foreign banks from Australia will result in more credit rationing for Australia’s businesses. Over the next 12 months, as businesses need to refinance their company debt, they may find that either (1) the price of money will go up further or (2) credit being denied. With the economy slowing, Australian banks are increasingly more careful with their lending. Furthermore, the recent lending fiascos (e.g. ABC, Centro, etc) will mean that they are in damage control mode, which implies that they will have to be even more stingy with their lending.

What is the longer-term effect of this?

Inevitably, this means that the weaker businesses will fail because their supply of credit is choked. Those who still have credit flowing through their balance sheet will find their debt repayment cost increases. That, along with falling revenue due to the slowing economy means that they will have to cut costs more aggressively. Since employees are one of the greatest costs for businesses, staff retrenchments will be undertaken. Laid-off workers will tighten their belts and cut their spending, which means other businesses will have their revenue cut. Businesses will become more pessimistic about the future, which means they will no longer invest for the future. This will result in businesses higher in the chain of production to suffer, which means they will have to cut the number of staffs. Many of these unemployed workers have large amount of debts, which means they will have to sell their assets (e.g. house) to de-leverage. This will in turn depress asset prices. Depressed asset prices will increase the chances of asset owners to fall into negative equity, which means that should they become unemployed, their debts will become bad debts for the banks. Bad debt for the banks will mean further rationing of credit. Further rationing of credit will start the next round of vicious cycle.

In engineering terms, this is called a positive feedback loop. It would not be easy for the government to intervene strategically to short-circuit this feedback loop.