The Aussie market is in for another good day. That’s because the Chinese just joined the Europeans in cutting interest rates.
Ah, the power of cheap money. It has the ability to numb investors’ thoughts of all but the most serious of economic troubles.
Actually, Mario Draghi at the European Central Bank didn’t lower rates on Friday. But he did the next best thing. He hinted that more stimulus would arrive at the December meeting.
Draghi is a master at this game.
What game, you ask?
The game of maintaining the market’s confidence.
That’s really all central bankers have left…confidence management. Market players know that lower rates don’t really do much for an economy anymore. The biggest boost from monetary policy comes via asset markets.
Draghi’s non decision last week fired up bond and stock markets in Europe and around the world.
As useless as a bit more monetary stimulus might be for Europe’s structurally unsound economy, Draghi’s words have important implications for Australia. As does China’s decision to lower their rates again. I’ll explain why in a moment.
First, let’s look at China’s latest efforts, from the Financial Times:
‘China’s central bank cut benchmark interest rates for the sixth time in 12 months in a bid to support an economy which is forecast to grow at its slowest annual rate in 25 years.
‘The PBoC said on its website that it was lowering the one-year benchmark bank lending rate by 25 basis points to 4.35 per cent and the one-year benchmark deposit rate to 1.5 per cent — its lowest on record — from 1.75 per cent.’
China has the largest pool of household savings in the world. It is not clear whether a reduction in interest rates will actually boost the economy. It’s just as likely that a reduction in interest income paid on savings could cause consumers to tighten their belts.
Funnily enough, this could be the best outcome for China. Because the alternative is much worse. That is, lower rates could encourage Chinese households to take on more debt. This would be a seriously bad scenario for China in the long term.
China already has incredibly high debt levels. The debt-to-GDP ratio is approaching 300%. That’s dangerously high for an emerging economy. Credit growth is still running at a faster pace than nominal GDP.
In other words, China is adding to its debt pile at a faster pace than the economy has the ability to service that debt. If debt growth slows, the economy will slow sharply too.
Households actually account for only a small portion of that debt. Most of it is non-financial corporate debt. Companies borrow simply to keep their heads above water, not to finance genuinely productive economic growth.
This is not a new development. China has been pursuing this debt-driven economic growth model ever since the global crisis of 2008. It’s been going on so long that most people have stopped worrying about it.
But the dangers of China’s growth are still very real. As Money Manger Jim Chanos said years ago, China is on a treadmill to hell. It can’t get off.
While the longer term implications for Australia are dire, in the short term you are seeing our economy benefit.
China’s screwed up economic growth model is the reason why billions of dollars of capital is escaping the country and looking for refuge in the world’s developed economies.
Much of it is going into residential property. And as my colleagues Phil Anderson and Callum Newman, writing in Cycles, Trends and Forecasts have pointed out, this trend is not going away. Today’s Financial Review reports on another chapter to this story…
‘One of China’s biggest financial institutions is offering zero-deposit home loans for off-the-plan apartments in Melbourne and the Gold Coast, a practice at odds with efforts by Australian regulators to tighten lending standards and cool the property market.
‘The banking division of PingAn Insurance, which has a listing in Hong Kong, was spruiking the loans to Chinese investors at a conference in Shanghai last week.’
Cheap money always forces investors to look for better returns. The ‘no-deposit’ carrot is an easy way to get around China’s capital outflow restrictions. But the Aussie property market looks as though it is now cooling. Clearance rates in the bubble cities of Sydney and Melbourne are now at multi-year lows.
Time will tell if it translates into price falls, but to punt on Aussie property continuing to rise from here is a highly risky play. Still, that’s what low interest rates force you to do….speculate rather than invest.
The Europeans are playing it a little different. Draghi’s promise of more stimulus for Europe is a stimulus for Australia too. Here’s how it works…
Our banks borrow heavily offshore. Because Europe is a capital exporter, the banks get a lot of their foreign funding from Europe. So Draghi’s words make Australia as an investment destination more attractive.
That’s why bank share prices responded so positively to Draghi’s comments on Friday. Much of the commentary was about how banks will maintain profitability via slight interest rate increases (all of the big four have now raised their variable mortgage rates). But the ongoing capital flows from Europe, providing a ready and cheap source of borrowing for Aussie banks will help maintain that profitability.
Sadly, these two actions by foreign central banks will simply exacerbate Australia’s structural problems. They will continue to direct capital into residential property and keep house prices high. This will make it more difficult for Australia to lower its cost base after suffering years of commodity-boom induced inflation.
For investors, the waters are still very murky. The recent rally has certainly lifted spirits, but as I’ll show you tomorrow, the market is still in a downtrend. So we’re not out of the woods yet.
Jim Rickards’ and Vern Gowdie’s bust thesis remain alive. More on that tomorrow.