We’re all 2% richer today and don’t even know it. Unless you’re overseas and get paid in Australian dollars. Then you might notice your dollars going further.
Our currency took off yesterday after the Reserve Bank of Australia did nothing to the interest rate at its meeting. So was the market expecting a rate cut then? Nope. The 2% jump came on the back of word games played somewhere in the ‘rates outlook’ section of the RBA statement. It implied that interest rates were likely to remain stable for the foreseeable future instead of falling further.
That was enough to trigger the big move in the exchange rate. 2% doesn’t seem big compared to other markets, but FOREX rarely swings so dramatically.
So why the change in the outlook? Well, RBA governor Glenn Stevens had been trying to persuade the Aussie dollar to fall to more reasonable levels. And the drop below 90 cents looks like a job well done to the Reserve Bank economists. So they’ve stopped mentioning that it’s ‘uncomfortably high’. Three cheers for Glenn.
But with no more rate cuts in the pipeline, the risk of further falls in the dollar is far lower. And so a short covering rally was probably what sent the dollar surging. In other words, traders betting on the Aussie dollar’s fall closed their position by buying back the currency.
There’s a fly in the ointment for the Reserve Bank of Australia’s apparent success – the recent uptick in inflation. It rose far more than the RBA expected. The rate jumped 0.9% last quarter, reaching an annual pace of 2.6%. It’s still within the 2-3% range the RBA tries to maintain though. So what’s the big issue?
Well, it’s only a big problem if you don’t pay attention to mainstream economics textbooks. You won’t find much mention of financial market bubbles there. But you will find them back in the world of reality. And they’re caused by a combination of speculation and leverage. The kind brought about by loose monetary policy. Like we’ve now got here in Australia.
The giveaway is that interest rates are now just 2.5%, less than the pace of inflation. If you can borrow money for less than the rate of inflation, a leveraged bet on anything, including toilet paper, becomes profitable. You borrow the money at 2.5%, buy toilet paper that goes up in price 2.6%, and bank the difference. We’ll be starting up a hedge fund that wipes off the profits.
Our toilet paper story is a snarky way of saying that speculative business ventures become profitable. Business ventures that depend on cheap debt, quick gains and investors who can’t get a decent yield on their savings accounts. Unfortunately, that type of economic activity is very fragile and tends to blow up as soon as the favourable conditions disappear – for example, when interest rates go up. The American subprime industry in 2006 is a great example. Probably better than toilet paper hedge funds anyway.
This is a global problem, but Australia is the recent entrant into the club of economies with interest rates below inflation. Financial market commentator Marc Faber, one of our guest speakers in March, explains that ‘A lot of economic growth was driven by soaring asset prices‘ recently becauseof the way debt financed speculation pays off in a low interest rate, higher inflation environment.
Again, that type of economic growth is a financial market bubble. And it can disappear quickly.
It’s not just monetary policy that’s in a pickle. Treasurer Joe Hockey explained to the Australian Financial Review that he has to get busy over on the fiscal side: ‘We can’t be sidetracked by the volatility of equities markets, the volatility of bond markets or currency…They’ll find their natural market point.‘ Instead, there are structural challenges to face in the budget. He’s flagging cuts that will be ‘driven by necessity not ideology‘ reports the Australian Financial Review. Oh, and ‘the age of entitlement is over.’ Hmm.
The politicians’ story goes that the government will release the Commission of Audit’s recommendations, have a healthy informed debate about which recommendations to follow, and then come up with a budget. That’s unlike Labor, who had a habit of coming up with policy without explaining why and then coming up with reports to justify them.
We find the lack of ideology in the new government disturbing. Ideology makes people consistent. Without it, political decisions are based on merit. That’s a good thing in the private sector. But in politics, merit is a matter of buying votes, scoring political points and getting re-elected. Take for example the government assistance programs for industry. Holden, Toyota, SPC Ardmona, drought stricken farmers…there are a lot of people clamouring for government money. And sometimes the government walks the walk on ending the age of entitlement, including this comment from Joe Hockey:
‘Ultimately it comes down to the fact that [SPCA’s parent company] Coca Cola Amatil was asking for taxpayers’ money to buy plant equipment to retool the factory…Abdul the kebab maker in Parramatta mall, to quote [former Liberal MP] Ross Cameron, is not asking for a new oven. These business are there to compete in the open market place. We want to encourage enterprise, not entitlement.‘
But then the lack of ideology bites, reports the Sydney Morning Herald:
‘Within minutes of Treasurer Joe Hockey declaring an end to ”the age of entitlement” on Monday Assistant Infrastructure Minister Jamie Briggs stood on a highway on the outskirts of Hobart and announced a grant of $3.5 million to a Tasmanian seafood processor, Huon Aquaculture. It would help ”provide the equipment to process fresh fish, as well as smokehouses and other machinery,” he said.‘
No doubt Abdul in Paramatta is thoroughly annoyed.
Last but not least, Australia’s balance of payments is in for a reshuffle too. It’s all happening in the Australian economy these days. Commonwealth Bank economist Michael Blythe reckons trade surpluses could become commonplace in five years time. That would reverse two centuries of current account deficits.
Becoming an exporting nation would signal a big change for our currency, foreign investment and jobs. If it happens, that is. Blythe is relying on the mining boom’s export phase, foreign investment by the Super industry, and a booming China for his predictions. We’re sceptical on all three.
But if he’s right, our currency could return to higher levels, foreign investment in Australia would fall, and our economy would be even more resource dependent.
It’s funny to see some economists explaining how a high dollar is killing our economy and exporters while the other economists reckon the dollar will surge on an export boom.
At least someone will be right. Our bet is it won’t be either group of economists though. China is not an economy to rely on. More on that tomorrow.
for The Daily Reckoning Australia