21 years is a long time to have uninterrupted economic growth. In fact, we think it’s a little too long. The odd, mild recession is not such a bad thing. It’s the economy’s way of re-allocating resources away from unproductive areas to productive ones. Of course, it’s not good for the individuals and families caught up in the adjustment, but that’s how a healthy economy works.
Yesterday, the Australian Bureau of Statistics reported that Australia’s economy grew 0.6% in the three months to June, making 21 years of straight economic growth for the lucky country. But things look like they’re slowing, fast. The quarterly rate of growth was less than half that of the March quarter, which came in at 1.3%.
Real net disposable income, a broader measure of the nations’ economic performance, increased by 0.7%. It’s up just 2.7% over the past 12 months, compared to 3.6% growth in the headline GDP number. We’ve mentioned the importance of the ‘real net disposable income’ measure before. Among other things, it takes into account the terms of trade. We reckon this is something RBA governor Glenn Stevens keeps a close eye on when trying to guess what the price of credit should be.
As you’re no doubt sick of hearing by now, the terms of trade are a relative measure of export prices to import prices. When the terms of trade rise, it means a country’s exports increase in value relative to its imports. When the terms of trade falls, the relationship is the opposite.
Over the past year, the terms of trade declined by 7.1%. In the three months to June it declined just 0.6%. Given the plunge in iron ore prices since June, you can expect the terms of trade to fall much further in the current (September) quarter.
That means Australia’s ‘real net disposable income’ growth is likely to be very weak by the end of the year. Which means the RBA will probably cut interest rates a few more times yet.
That’s not exactly news. Despite the best attempts of the cheerleaders to tell you all is well, the market still expects more cuts to official interest rates. You could see an official rate of 3% by Christmas. We’re certain the cheerleaders will twist this into some sort of Santa Claus Christmas present and that it’s great news leading into a consumption economy’s busiest period. But as we’ve pointed out before, very low interest rates are not exactly a sign of good economic health.
Ask Japan, the US, Europe or Britain.
That lower rates are on their way is inevitable. The question is how low can they really go, and how effective will the cuts actually be?
As Dan Denning pointed out in yesterday’s Markets and Money, Australia runs trade deficits. Apart from a spike in iron ore and coal prices that turned the deficit into a surplus during 2010 and 2011, we generally import more than we export. Put another way, we consume more than we produce. It’s been that way for decades.
As a consequence we have foreign debt of around $750 billion, resulting from continual borrowing to finance our standard of living. This borrowing requirement means Australia is a chronic importer of capital.
Which is where the RBA comes into it. They want to cut interest rates to stimulate consumption. But because Australia doesn’t save enough to finance its excess consumption, it must borrow from offshore to do so. Foreign investors finance about 40% of bank assets, which is mostly made up of residential property. Given this reliance on foreigners’ capital, we should probably think about keeping them happy.
But we’d guess they won’t be too keen on financing Australia’s continued over-consumption (and high house prices) for a lower rate of interest. In this situation the RBA’s moves could prove impotent. Lower official rates might not translate into lower market rates. What will that do to everyone’s slavish belief in the miracles of central banking then?
This is already happening in the local deposit market. High interest accounts of around 5-6% are already way above the official rate of 3.5%. Because of the banks’ need to reduce their reliance on foreign capital, they need to entice domestic savings into the system by offering a decent rate of return.
Lower official interest rates will put pressure on the banks’ interest margins. They’ll find it difficult to offer lower mortgage rates AND lower deposit rates to attract domestic savings. That means they’ll probably ignore RBA cuts and keep their mortgage rates pretty high.
Lower mortgage rates are meant to increase volumes. So what banks lose on interest margins they more than make back through higher volumes. But just about anyone who was going to take out a mortgage in Australia has probably done so by now. Lowering mortgage rates will not result in a profitable volume boost for the banks.
So if lower interest rates are not passed on by banks, where does the ‘economic stimulus‘ come from? We think it will happen via the Australian dollar. The prospect of lower rates in Australia will discourage foreign capital from selling their currency and buying ours at such a high exchange rate. The currency will have to come down and increase foreigners’ purchasing power if we want to continuing borrowing from offshore.
Or we could just pray, like the guys at Fortescue metals, that iron ore prices and our terms of trade will come roaring back. After all, China has policy tools. It’s just because of an upcoming change in leadership that these tools are still sitting in the shed, unused.
for Markets and Money
From the Archives…
The Pin-Up Stock of the Iron Ore Boom
31-08-2012 – Greg Canavan
How Australia Grew Fat and Lazy Off the China Boom
30-08-2012 – Greg Canavan
Why You’ll Never Change Our Mind About Inflation
29-08-2012 – Nick Hubble
The Make Believe World of Economists, Continued…
28-08-2012 – Bill Bonner
Iron Ore, a Love Story
27-08-2012 – Dan Denning