The age of record-low interest rates means Australia’s economic transition may be built on sand

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There’s a fundamental problem with the way central bankers have been running monetary policy and it could mean Australia’s remarkable economy is a house built on sand.

In consistently cutting rates to pull forward demand from the future, global central banks have sought to forestall economic weakness.

As we are seeing in developed markets offshore, it is looking increasingly likely that policy may have hit the bounds of efficacy in many countries.

Australia is no different than other nations where monetary policy is struggling for traction. The RBA itself has pursued policy that is the very definition of borrowing from the future, encouraging consumers and households to increase borrowings to fund consumption now with debt to repaid later.

Sure with an official RBA cash rate at 2% – not the zero, near zero, or negative rates of much of the developed world – Australia still has some room to move policy, and so encourage households and consumers to spend.

But since the GFC, the RBA’s rate cutting activities and encouragement for consumers to spend has fueled a big run-up in house prices and the associated leap in borrowing which has taken Australian household debt as a percentage of household disposable income to new all-time highs.

It’s the very definition of borrowing from the future as the debt needs to be repaid from future earnings. That’s likely to lead to a point where consumption will be foregone for saving and debt reduction.

Source: RBA Chart Pack

But the RBA’s rate cutting program has been successful at continuing Australia’s remarkable run without a recession to 25 years. And now, after the biggest mining investment and terms of trade boom in its history, the Australian economy looks like it is making the economic transition it needs by spreading growth through the broader economy.

That was certainly the message in the latest update of the NAB’s authoritative business survey which showed a very solid improvement in both business conditions, which rose from 8 to 12, and business confidence which came in at 6 from last month’s print of 3.

That strength and the economic transition was reflected by the NAB’s chief economist Alan Oster who said “the lift in business conditions to these levels not only suggests that Australia is withstanding the uncertainty offshore, but that the recovery in the non-mining sectors of the economy have in fact stepped up a gear this month”.

That’s clearly great economic news for the continuation of Australia’s epic run without a recession.


Particularly so because Australia’s Q4 2015 economic growth rate was largely built on household final consumption contribution. That in turn was built on Australian households – consumers – spending more and letting their savings rate fall to a post-GFC low of 7.6%.


But is this sustainable?

The recent falls in the ANZ-Roy Morgan weekly consumer confidence index, which is down 3.8% over the past 4 weeks, and the Westpac-Melbourne Institute consumer sentiment index, which fell 4% in April, suggest households will be less reluctant to run down their savings.

Indeed, while the headline numbers in the NAB business survey were solid, there were signs that the consumer-facing sectors are actually under a little pressure with retail back at the zero line while finance, property and business, together with household services, well off their peaks.

Likewise, the recent engines of growth, New South Wales and Victoria, are also well off their peaks.

None of this is threatening to Australia’s economic recovery, in the sense that it’s not signalling a collapse around the corner any time soon. Indeed, overnight the IMF forecast that Australian growth “is expected to remain below potential at 2.5 percent in 2016 but to rise above potential to 3 percent over the next two years, supported in part by a more competitive currency”.

That’s hardly terrible and if growth falters or the Aussie dollar rises too far, then the RBA can cut rates and count on such a move as still being effective. At least for the moment.

But structurally by borrowing from the future, driving up housing prices, increasing household debt levels, and relying on finance and real estate to drive consumption, the RBA is setting up the economy for an eventual day of reckoning.

A big one.

In his excellent interview with Business Insider’s Ben Moshinsky the former PIMCO boss Mohamed El-Erian made the strong point that the global experiment pre-GFC of relying on finance for growth failed.

There is an obvious analogy here for Australia in its current housing, construction, borrowing, and consumption-based economic transition. It could be that like global policy makers before it, the RBA has fallen “in love with the wrong engine of economic growth”:

The period up to 2007, 2008 was the unfortunate romance. The notion that financial services could power economic growth, that it was the next level of capitalism, spread across the world. People thought you went from agricultural to industry to manufacturing, and then, if you’re really good, you make it to finance. Phase one will be seen as falling in love with the wrong engine of economic growth.

Perhaps regulators and the market has seen the analogy too.

Australia’s banking regulator, APRA, called time on investment lending and has aggressively sought to enforce its 10% cap on such lending growth over the past year. Australia’s big four major banks are languishing near their February lows, while ratings agency Moody’s says Australian banking faces a growing problem from investment lending as the costs of carrying the debt associated with these loans increases because rental yields have fallen to record lows in Sydney and Melbourne.

Moody’s sounded alarmingly close to Hyman Minsky’s very definition of a “ponzi” unit in his influential Financial Instability Hypothesis: “For Ponzi units, the cash flows from operations are not sufficient to fulfill either the repayment of principle or the interest due on outstanding debts by their cash flows from
operations,” Minsky wrote.

Similarly Moody’s said the decline in rental yields (my emphasis):

…has increased the level of ‘cashflow’ losses suffered by residential property investors over the past three years and made investors dependent on greater levels of house price appreciation to cover their losses. A greater dependency on house price appreciation makes residential property investing, and in turn, investment loans more risky.

That’s a massive risk for the banking industry as evidence grows that Australia’s apartment price crash is real.

Sure, the idea that the Australia’s housing market will collapse, or the economy will fall in a hole is remote. But as El-Erian pointed out: “who would have ever thought we’d be living in a world of negative nominal interest rates?”

Australia’s growth, its very economic transition, is predicated on borrowing from the future and relying on the wealth impact of finance and housing. We’d hope that the relative low dollar – at 76/77 cents around long run average levels – would afford Australia’s services, and remaining manufacturing industries, the chance to bridge the gap in economic output.

Because at some point all that household debt need to be repaid.

That’s when we’ll find out just how miraculous Australian growth has really been.