RBA’s response welcome but still not targeting Australia’s Achilles’ heel: USD liquidity

• Australia was often referred to as the lucky country, but the question is how resilient the economy can be under a global sell-off with its banks scrambling to access USD financing. The sharp widening of the USD-AUD cross-currency basis swap shows a big challenge, especially when a quarter of their funding comes from overseas and become a structural imbalance of Australia’s financing and the economy.
• Against a USD shortage, Australian banks have a few strategies. First, they can try to pass on higher funding costs to borrowers, it will be much more difficult nowadays given the demand to support the economy. Therefore, banks’ profitability will be hammered by lower interest margin at the worst of all times: a plummeting economy and historically law rates, especially after the rate cut this morning.
• The Reserve Bank of Australia (RBA) took a number of actions at today’s emergency meeting, aimed at lowering funding costs and restore confidence. First, it lowered the cash rate once again by 25 bps to a historic low level of 0.25%. Second, it also announced quantitative easing (QE) geared to flattening the curve and targeting the 3-year government bond yield at 0.25%. Thirdly, the RBA established an AUD 90 billion lending facility for banks to support SMEs for three years.
• Although these decisions are welcome, they do not solve the most immediate risk Australian banks are facing, namely USD and liquidity shortage. The RBA could reopen the FX foreign exchange swap line which it established with the FED back in 2008, expired since 2010. Domestically, the RBA could buy commercial papers and corporate bonds beyond flattening the yield curve by government bonds.
• Beyond the RBA’s response, the good news is regulators are also taking measures to cushion the impact of the coronavirus global panic on Australian bank. In order to allow room for short term loan defaults and further lending to support corporates, banks may be allowed to run down their original "unquestionably strong" common equity tier 1 capital ratio, which currently stands at 10.5%. As the key pressure of Australians banks comes from liquidity, further actions may include easing the liquidity coverage ratio (LCR), especially for USD liabilities.
• All in all, Australia’s structural characteristic, namely the very high dependence of foreign funding intermediated by banks to finance a massive mortgage market, means trouble at a time of global dollar liquidity shortage. Even if the RBA actions today are welcome, together with those to be taken by other regulators, they will probably not be enough as they do not target the root cause of the problem. It will be important for Australia to reinstate the USD swap line the FED had opened with RBA in 2008 and, if needed, create flexibility in existing liquidity requirements, especially in USD.

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