Yesterday I talked about the persistently strong Australian dollar as a major economic challenge for Australia. Part of the reason for that is because interest rates here are attractive relative to other parts of the world. But are they really?
Today I’m going to explain why they are not. When you take into account the risks, foreigners are playing a dangerous game by chasing ‘yield’ in Australia.
Before I get to that though, what about iron ore? It fell another 2% overnight and is now trading at US$89/tonne. Where’s this bounce that everyone (especially the iron ore miners) is expecting? It will come at some point, but it’s likely to be weak when it does.
The great hope of the iron ore bulls is that a lower price would take out uneconomic Chinese production, freeing up supply for Australia’s relatively low cost producers (both large and small). I never bought this argument, which is why I have long thought the price would hit US$80/tonne before the year was out.
Think about it. The Aussie iron ore industry has for years relied on China’s uneconomic production of steel feeding uneconomic construction of property and all types of infrastructure. Yet they have faith that Chinese iron ore miners will somehow adhere to economic principles and shut down when the price falls below their cost of production.
Don’t they know that China is different? China produces stuff to maintain full employment, not to generate an economic profit. Sure mines will close eventually (after the government gets sick of subsidising losses) but that could still be some time away. The cost of subsidising a loss is likely to be much less than dealing with rising unemployment and potential unrest in certain communities. So the subsidies will go on and the supply glut will intensify.
By the way, the lack of concern for economic profit is the fundamental reason why I’ve been bearish on China for so long. When economic profit is below the cost of capital in so many areas, which it is in China, problems must emerge somewhere. Parts of the economy must bear the cost for the profligacy of the other parts. That’s what you’re seeing now with slowing growth…and it will get worse.
Let’s get back to interest rates and the dollar. Foreign investors remain happy to buy Aussie dollars and assets because the yield is more attractive here than in their home countries…whether it’s Japan, Europe or the US.
And keep in mind, these foreign investors don’t really have to care about local inflation. Savers like you and me do, but no one gives a hoot about you and me, so pipe down. After taking inflation into account, the real official interest rate is 0%. On the other hand, for the foreign investor experiencing very low inflation at home (as in Japan and Europe, for example) the nominal yield in Australia looks good.
But buying Australia because the yield looks good is akin to buying a stock because it pays a good dividend. Such an action doesn’t take into account the underlying risk. When it comes to a company, you look at the business model and determine whether revenues and profits are sustainable…and therefore whether the current dividend is sustainable.
When it comes to assessing a nation, it’s a little different but essentially the same principle. That is, you have to assess the nations’ business model to determine whether the yield you’re receiving is sustainable.
Australia’s business model of the past 10 years is now in the process of changing. That is, the events that supported income and economic growth are no longer sustainable. But foreigners aren’t too concerned just yet because unlike companies that go through structural change, nations have a backstop.
The backstop in Australia’s case is the government. It has relatively low debt levels and a AAA rating. Over the past five years or so, private investors globally have been conditioned to expect governments to use their credit (taxpayer funds) to bail out economically sensitive industries.
Now, keep in mind that the largest asset class that foreigners invest in is bank debt. They are attracted to it because of the perceived safety…if a bank gets into trouble, our AAA rated government will bail the banks out…foreign investors perceive that they have little risk.
But this is just the perception of safety. Banks are safe and profitable because two historic terms of trade booms (early to mid-2000s and 2008 to 2011) led to an investment and employment boom, which delivered strong wages growth and a per capita GDP amongst the highest in the world.
Aussies parlayed this historic income boost into the property market, taking on debt to do so. The banks provided the debt and made billions in the process.
But with the fall in the iron ore price, the terms of trade boom is turning to bust (as they all do), which will begin to detract from national income growth. National income in the current June quarter will very likely have gone backwards.
This is like a company suffering from falling revenues. Not the end of the world, but not good either.
When a nation suffers from low or falling revenue growth, it has only a few levers to pull. There’s fiscal or monetary policy. Foreigners think the government will bail them out if anything goes wrong. But the government (as demonstrated in the last budget) has some major structural fiscal issues and lending its balance sheet to help the banks would blow the AAA rating up.
That leaves monetary policy. The Reserve Bank of Australia has been pulling this lever ever since the terms of trade started to decline back in 2011. From 4.75% in October 2011, interest rates are now at historic lows of 2.5%. So far, the reduction has offset the negative effects of a falling terms of trade.
But the boost is beginning to wane. As the terms of trade continues to decline and employment struggles after the mining investment boom, calls will grow for more interest rate stimulus. That’s not happening now, but if house prices start to fade in the second half of the year (as I think they will), then you’ll hear the usual calls for more.
At this point, our yields won’t look so attractive, especially with the US and the UK moving slowly back to some sort of interest rate normalisation. (You’ll hear about that tonight as the US Federal Reserve concludes its two day meeting).
If interest rates continue to move lower in Australia on the back of persistent economic weakness, when do foreigners decide to bail?
I don’t know of course. No one does. But if official interest rates move below 2%, foreign appetite will wane and our dollar will really collapse. Such low rates could lead to a whole other range of unintended consequences, such as booming house prices in a recessionary economy. So I hope it doesn’t come to that.
The question is, though: at what point does the RBA say no to more cuts? When do they acknowledge that interest rate cuts have only a short term impact on growth and that Australia has deep structural problems that it must deal with rather than constantly relying on interest rates to support growth?
I actually put those questions to the bank a few weeks ago. I’ll let you know what their response was tomorrow.