Capital inflows and the Global Financial Crisis

Australia has imported capital for most of its history, which has allowed investment to consistently exceed the volume of domestic savings. As a result, Australia has enjoyed the benefits of a larger capital stock which, through lifting the amount of capital per worker, has resulted in a more productive workforce, with higher wages supporting local living standards.

The nature of the inflow has changed through time. In the earliest period of our colonial history, the British allowed domestic officials direct access to British government accounts. Subsequently, significant sums of private money flowed in to buy land and to invest in projects, such as the extensive rail network established in the nineteenth century. Private direct investment then grew strongly, particularly during the period while Australia had high tariff barriers. [1]

After the opening up of the financial system in the 1980s, the nature of the inflow changed once more. Australian banks started to borrow significant amounts of capital offshore for domestic on-lending. [2] This worked for many borrowers who could not access foreign capital markets themselves, or who could borrow more cheaply via the banks given the latter’s high credit ratings.

The Global Financial Crisis

This borrowing model ratcheted up progressively, reaching its peak just before the financial crisis. Australian banks were borrowing offshore heavily, with relatively short loan durations. Banks became less dependent on the domestic savings of depositors, and more dependent on obtaining finance from London and New York. As the RBA figure below shows, our banks were issuing up to $20bn in bonds per month just before the crisis, with about three quarters of those issued offshore. This came to a crashing halt late in 2008, when lending dried up almost completely.

Many foreign banks faced the same problem. Virtually no institution or government was willing to lend money to banks at the height of the crisis. No one could be sure which banks were safe and which would be caught up because of their own mistakes, or the failure of an important counterparty.

Reactions to the Global Financial Crisis

With its banks in deep trouble, the Irish government jumped in and provided a government guarantee to anyone who loaned money to its banks. All the other governments then had to match that decision, and many governments guaranteed bank borrowing during the period. [3] The guarantees did not come without pain for the banks; the government charged them a cost of guaranteeing their borrowings. However, it is clear from the RBA figure that the Australian government guarantee successfully allowed Australian banks to re-enter the capital market.

At that stage, the risk of a catastrophic collapse in the availability of credit in Australia was averted. There was no risk of a sudden stop to capital inflows nor a halt in the flow of credit to Australian businesses and households. In some sense, there was a run on banks globally by participants in the wholesale markets. Rather than households lining up to take their savings out of banks, as in a traditional bank run, the crisis saw wholesale parties refusing to roll-over loans they had made to banks. This reduced the funds banks had available to lend, risking a credit squeeze.

The RBA’s review of the whole scheme was very positive: “By ensuring continued access to funding markets, the scheme successfully supported the Australian financial system and economy through the period of extreme pressure on banking systems globally…The scheme incurred no losses, suggesting that the settings were appropriate for the circumstances, and earned fees of $4½ billion…”. [4]

Clearly, policy makers in Australia were very concerned about the risk we had run. They have joined enthusiastically with global regulators in limiting the offshore borrowing risk faced by the banks. [5]

The GFC has caused three primary consequences for the regulation of capital markets. Firstly, banks have been incentivised to obtain more of their funds from retail depositors on the assumption that they are stickier. Secondly, they have been required to hold much bigger buffers of liquidity, so they are able to withstand a run for longer. Thirdly, they have been required to lengthen the tenor of their borrowing from wholesale markets so that there is less at risk in any given month.

Capital Inflows – Into the future?

Looking ahead, there are more fundamental questions about Australia’s development model. Will we remain as dependent on foreign savings to fund our heavy investment, and will the banks remain a key channel by which such savings are directed into productive uses?

As the structure of the economy evolves, it seems likely that our reliance on foreign capital will decline somewhat. The resources industries appear to have invested in advance of demand, and the services sector appears to be less capital intensive. However, with population growth expected to continue strongly, infrastructure and housing will continue to require investment. Currently, domestic banks provide much of the finance for these developments, and a significant part of that is borrowed offshore, despite tighter capital controls compared to the pre-GFC era.

The big unknown is how domestic savings will evolve. The need to finance investment in advance of savings opens up the need to access foreign capital. Household savings have remained well above their pre-crisis lows, and corporates have been net savers for a substantial period. However, the public sector continues to run big deficits, driving most of Australia’s current need for capital inflows. [6] With the deficit unlikely to close soon, Australia will continue to depend on financing from New York and London, not because of the banks but because of the government.

Dr Rodney Maddock is a Professor of Finance in the Australian Centre for Financial Studies at Monash University and Vice Chancellor’s Fellow at Victoria University. He is also a Non-Executive Director of the Committee for the Economic development of Australia (CEDA).

[1] Ville, S., & Withers, G. (Eds.). (2014). The Cambridge Economic History of Australia. Cambridge: Cambridge University Press.

[2] D’Arcy P, M Shah ldil and T Davis (2009), ‘Foreign Currency Exposure and Hedging in Australia’, RBA Bulletin, December, pp 1–10

[3] Schwartz, C. and N. Tan (2016) “The Australian Government Guarantee Scheme: 2008–15”, RBA Bulletin, March, pp 39-46.

[4] Ibid

[5] Reserve Bank of Australia (2017) Financial Stability Review, Sydney

[6] CEDA (2016) Deficit to Balance: budget repair options, Melbourne