Rate-Cut Ammo Running Low Challenges RBA as China SlowsMichael Heath
Australia entered its last recession with the benchmark interest rate at 12 percent. Now, as a once-in-a-century mining-investment boom wanes, the central bank finds itself with little conventional ammunition.
The Reserve Bank of Australia’s overnight cash rate, at a record-low 2.75 percent, is at a level it took the Federal Reserve and Bank of England just months to exhaust before they turned to quantitative easing. While economists see just a 12 percent chance of an Australian contraction by mid-2014, a pronounced downturn would pose unprecedented challenges.
Traders are betting Governor Glenn Stevens will cut rates again to weaken the currency and boost exports. He could emulate global counterparts in stating how long he’ll keep borrowing costs low. In a worst-case scenario, where a financial crunch accompanies a slowdown, economists say any asset purchase program would face a scarcity of government debt, forcing the RBA to mull options including buying foreign bonds.
“The real interest rate is already very very low, so there already has been a big movement,” said James Morley, professor of economics at the University of New South Wales and a member of the shadow RBA board, a group of academic and market economists that assigns probabilities to cash-rate moves. “The short term policy rate is the main instrument, but when that runs out, you have to do other things.”
The RBA declined to comment on its policy settings or whether it has contingency plans. Stevens, who was an economist at the central bank’s research department when Australia had its last recession in 1991, said in remarks in Brisbane July 3 that the RBA is still running a normal monetary policy.
Australia proved the largest developed nation to avoid a recession during the 2007-2009 global financial crisis thanks to 425 basis points of rate cuts, government handouts and surging exports to China, which almost quadrupled the past five years. That dependence is now a liability. The China-led resources boom is over, Australian Prime Minister Kevin Rudd has said repeatedly since retaking office last month.
China’s economy extended the longest stretch of sub-8 percent growth in at least two decades in the second quarter, a government report showed July 15. With Premier Li Keqiang seeking to rein in credit, the country’s largest private shipyard has sought a bailout, underscoring prospects demand will recede for Australian iron ore and coal.
“For years it was assumed China would maximize gross domestic product, but increasingly the official view under the new administration is that the quality of growth does matter and that they’re willing to tolerate slower growth,” said Sean Callow, a senior foreign-exchange strategist at Westpac Banking Corp. in Sydney. “The RBA is like the Fed, it has a dual mandate for employment and prosperity as well as the inflation target. So sitting back and doing nothing is not necessarily an option.”
A China hard landing could tip Australia into a contraction, according to economists at Barclays Plc. A recession would put strains on a nation where household debt totaled 147.3 percent of disposable income in the first quarter and where banks rely on wholesale funding -- typically short-term instruments sold to investors -- for about a third of their total.
Stevens already has overseen 2 percentage points of rate cuts since late 2011, and the RBA says the effect of those reductions is apparent and has further to run. Unemployment rose to 5.7 percent in June, the highest level since 2009. That still compares favorably with 7.6 percent in the U.S. and 12.2 percent in euro-zone economies.
Pockets of weakness have spread as job-intensive industries such as manufacturing were squeezed by a strong currency in recent years and missed out on the mining-investment boom. The unemployment rate was 10 percent or higher in 10.3 percent of the nation’s approximately 1,400 regions in the three months through March, up from 8.1 percent a year earlier, according to a government report released this month.
Economists predict the RBA will lower the main rate to 2.5 percent and keep it there for about a year. Traders are pricing in a 77 percent chance of a quarter percentage point cut to 2.5 percent at next month’s policy meeting, according to swaps data compiled by Bloomberg.
Because about 90 percent of home loans in Australia are financed at floating rates tied to the central bank’s benchmark, reductions have a more direct impact on the economy than in the U.S., where most mortgages are fixed rate.
Stevens’s counterparts have been surprised at the speed at which normal can become abnormal. Fed Chairman Ben S. Bernanke and his policy panel said in August 2007 that inflation was the central concern, days before a seizing in money markets prompted a reversal in stance. Seven months later, the Fed stepped in to prevent the disorderly failure of Bear Stearns Cos.
Should traditional rate cuts approach exhaustion -- in the U.S., the Fed began turning to asset purchases when its target was 1 percent -- Stevens may have to shelve a preference for conventional policy and embrace other steps to boost growth.
“It would be useful for the RBA to be thinking about such possibilities now,” said Saul Eslake, chief Australia economist at Bank of America Merrill Lynch in Melbourne, who has worked in Australian financial markets for more than a quarter century and wrote a note last month mooting the possibility of QE in the country. While officials may be looking at contingency plans, “I wouldn’t expect them to say so publicly, not least for fear of being accused of talking the economy down,” he said.
Any RBA shift to using the bank’s balance sheet as its main tool would likely push Stevens to look beyond Australia’s government and corporate debt market, which is less than half of America’s, relative to the economy’s size.
Years of budget surpluses and limited deficits have left a small amount of government bonds relative to other countries, and companies have eschewed borrowing via debt sales. As a result, outstanding corporate and government debt is about A$620 billion ($571 billion), or 42 percent of the nation’s A$1.45 trillion GDP, according to a Bank of America Merrill Lynch index. In the U.S. the total is about $20 trillion, exceeding the nation’s $16 trillion GDP.
International investors also hold about 70 percent of Australian government debt, reducing the amount the RBA could purchase unless foreigners were willing to sell.
At the same time, a recession would test the government’s commitment to fiscal discipline, potentially leading to increased federal borrowing. Rudd and opposition leader Tony Abbott, who face off in an election due by Nov. 30, have pledged to return the budget to surplus.
Any increase in government financing needs could be met by RBA liquidity, either directly -- a step eschewed by major central banks since the Great Depression -- or via the secondary market. The Bank of Japan’s current QE program has it buying the equivalent of about 70 percent of government debt issued.
One alternative for the RBA would be buying residential mortgage-backed notes, something it did through repurchase agreements to accommodate banks’ desire for more liquidity as global credit markets began seizing up in 2007. The market totaled A$110.1 billion as of April.
Another tool deployed during the crisis was a government guarantee for bank debt. Rudd, then in his first stint as prime minister, announced the step in October 2008, citing what he called “acute funding pressures” for lenders. The RBA set up a liquidity facility in 2011 to allow banks to meet capital buffers under international regulatory rules known as Basel III.
Another quantitative-easing option for the RBA would be to purchase foreign bonds. That would have the added advantage of putting downward pressure on the currency -- should it prove “stubbornly resilient to a deteriorating economic environment,” according to Merrill Lynch’s Eslake.
A more likely scenario is one where the Aussie declined on its own as a Chinese slowdown infected Australia, according to former RBA board member Warwick McKibbin. He said in an interview that exchange-rate depreciation would help rebalance the economy without the need for asset purchases.
The Australian dollar already has begun retreating from the record highs past $1 that hammered the nation’s manufacturing and retailing industries. The Aussie fell 12 percent last quarter, the biggest slide worldwide after the Syrian pound. It was at 92.70 U.S. cents at 11:50 a.m. in Sydney, compared with the average of $1.0175 the past three years.
“At this point, I don’t think QE will be necessary,” said Mardi Dungey, a professor of economics at the University of Tasmania who began her career at the RBA, highlighting the currency’s drop. Foreign central banks “who have really been most prominent in their use have well-developed, deep and liquid debt markets,” she said.
Besides accumulating assets, Stevens could emulate counterparts by adopting a “forward guidance” policy such as stating an intention to keep the cash rate low so long as inflation remains within target and unemployment stays above a certain level, said UNSW’s Morley.
“The RBA has considerable scope as a flexible inflation targeter to undertake unconventional monetary policies,” Morley said. “I can see no obvious restrictions on balance-sheet measures that would involve purchases of foreign or longer-term assets.”
The RBA’s charter offers it operational flexibility should abnormal measures be required. Sections 10 and 11 of the Reserve Bank Act 1959 tasks it with seeking currency stability, full employment and prosperity, and requires it to inform the government “from time to time.” The Fed employed emergency authority to make credit available beyond the banking system.
The RBA’s current balance sheet amounts to about 6 percent of GDP -- the level of the Fed’s at the end of 2007. The American central bank’s total swelled to 23 percent as it embarked on three rounds of quantitative easing.
Any push to broaden the range of securities bought in the event of a recession may open the RBA to political scrutiny that it hasn’t had to face before. Local politicians may have an incentive to press for purchases of state government bonds. Yields on those securities soared to 1.34 percentage points above those on federal notes in December 2008, from 0.51 point two months earlier, illustrating their vulnerability to crises.
Bernanke had to contend with calls to cease asset purchases from some politicians worried new bubbles would result, and pressure to extend them into areas such as student loans because the U.S. economy wasn’t recovering quickly enough.
“Purchases of private assets are always fraught with political difficulties,” said Morley.
Policy makers elsewhere in the Asia-Pacific region have looked beyond their main monetary policy tools as capital inflows complicate the response to growth risks, with Singapore and Taiwan taking steps to cool property prices.
Singapore may report inflation accelerated in June, a Bloomberg survey showed before a report today. Taiwan may say industrial production grew for the first time in five months. A euro-zone consumer confidence indicator and a U.S. house-price index are due.