A Crisis in Australia will Result from a Crisis in China

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Well, that interest rate cut certainly took me by surprise. In Tuesday’s Daily Reckoning, I made the case that cutting interest rates, in an attempt to increase demand and raise prices, was a stupid policy doomed to failure.

So I reasoned (unreasonably in hindsight) that the RBA would hold off on an interest rate cut for now. I was wrong.

It turns out the RBA is working from the same playbook as the Fed, the Bank of Japan, and the European Union. The problem is that the playbook only has one play…it’s called the Hail Mary.

That is, cut interest rates and hope for the best.

While the academic models that come with the playbook suggest it should work, in the real world it’s clearly not happening.

The common sense model tells you that lower interest rates promote increased debt accumulation. This may provide a short term demand boost, but, before long, the increased debt servicing costs that come with higher total debt levels offset the benefit. The economy just ends up with higher debt levels that need to be serviced, making it more susceptible to employment downturns — that is, riskier.

This is an important issue for Australia, which I’ll get to in a minute.

While the academic models that drive central banking behaviour focus only on the demand side, they don’t seem to take into account the impact on supply.

Central bankers want inflation. They want our cost of living to increase so the gargantuan pile of debt they have helped to create will inflate away nicely. Inflation is a result of demand exceeding supply. Deflation happens when supply exceeds demand.

Now, these central banking bozos have facilitated the largest global build up of debt in history. Debt is simply future demand brought forward. Because of the current size of the debt (or future demand brought forward), there is simply no way to increase demand enough to bring about sustainable inflation.

But guess what else low interest rates do?

They increase supply! They help lower the cost of production so that the supply of goods and services is greater than it would otherwise be. Zombie companies that should go out of business and stop producing stay afloat in a low interest rate environment.

Therefore, supply exceeds demand and you get deflation. Central bankers interpret this signal in entirely the wrong way, lower interest rates some more, and make things worse.

So you really shouldn’t expect too much from this interest rate cut. Yes, it will support equity and house prices at the margin, but it’s difficult to see how it will deliver a lasting benefit.

The RBA has merely joined the rest of the world in fighting the currency war. Strategic Intelligence editor Jim Rickards said as much in a tweet following the decision:

Aussies are always in the fight. The #CurrencyWars are no exception. Australia can cut rates with the best of them!

Last week’s feeble inflation figure gave the RBA the cover it needed to put pressure on the currency. In addition, it came just as Westpac [ASX:WBC] and ANZ Bank [ASX:ANZ] delivered worse than expected results.

It’s so much easier to cuts rates (politically) when the banks deliver ‘disappointing’ earnings.

While the initial response to the rate cut was positive (the ASX 200 was up more than 2% on Tuesday) there has been no follow-through buying, which is a concern.

Perhaps this shouldn’t be surprising though. Do you remember what happened the last time the RBA cut interest rates? Check out the chart below. It shows the ASX 200 with the February and May 2015 interest rate cuts indicated.


Source: BigCharts

[click to open in new window]

As you can see, the market knew interest rates were coming, rallying strongly in early 2015. At the time, the property market was on fire and housing construction and consumer spending were booming too.

While the market continued to rally for a month after the February 2015 rate cut, momentum quickly ran out. The May cut provided respite for a little while, but the trend had turned.

Now, the interest rate cut comes with housing construction activity topping out, while the bad debt cycle looks to have turned for the banks. On the positive side, household consumption should hold up, given low interest rates and the ‘wealth effect’ of high house prices.

But I can’t really see how this rate cut will be any different from the last few.

And now the RBA is getting into dangerous territory. How low can it go before foreign capital starts to worry about the lack of return for the risk it’s taking on? After all, Australia’s economy is much more indebted and risky than it was just a few years ago.

Remember, Australia has net foreign debt of around $1 trillion. On a gross level, it’s much larger. That’s a lot of foreign capital in the economy. It’s capital that not only sustains our standards of living, but props up our house prices as well. It’s foreign capital that will only stay here if it gets a decent return.

So what happens when a genuine crisis hits? How much more can the RBA cut? Can it go to zero, or will our foreign creditor revolt before we hit that level?

As always, it depends on China. A crisis in Australia will result from a crisis in China. Could that be coming sooner than everyone thinks?

More on that tomorrow…

Cheers,

Greg Canavan,

For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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