Thursday, November 4, 2010

A benevolent bust?

The FT's Lex column has an interesting take on the RBA, commodities and the housing bubble today:
Most Australians spent the first Tuesday in November obsessed with the Melbourne Cup. But the “horse race that stops the nation” did not prevent Glenn Stevens from working. The governor of the Reserve Bank of Australia raised interest rates 25 basis points to 4.75 per cent. With that surprise thrust upon it, the Australian dollar promptly reached parity with the US one. Since deregulation in 1983, the currency has never been higher.

Of course the exchange rate against the US – the world’s fourth most traded combination – is benefiting from the Federal Reserve’s efforts to drive US rates down. But the core of the Aussie’s strength is the endless amount of dirt and rock the country digs up and China’s endless demand for it. Australia’s terms of trade – a measure of export and import prices – have almost doubled in the past decade to record highs. The persistent current account deficit was all but eliminated last quarter.

As the guardian of a heaving economy, and with inflation in check, Mr Stevens appears to have a job most central bank governors would kill for. But international markets may be driving him into a corner. During the past two decades, the RBA’s base rate has moved broadly in line with the CRB commodity index. Such dependence on one sector is worrisome, particularly when that sector, commodities, is on a bull run.

The housing bubble is the RBA’s chief concern: median prices in all but one big city are at all-time highs, according to the Australian Bureau of Statistics. Lenders are also worried. A standard variable rate mortgage now demands 2.9 percentage points on top of the RBA’s base rate – the widest margin in the past decade. Another 1 percentage point interest rate rise is expected next year. Mr Stevens may yet face the awful proposition of fixing the economic fall-out from a housing bust while interest rates are tied to booming commodities. No wonder he decided to take brave pre-emptive action – even if it meant working on Cup day.

This blogger must ask the rather sticky question would it be so bad if the housing bubble busts in the near future whilst the commodities boom is still in full swing?

The financial crises that usually accompany asset price busts involve capital flight and a falling currency. But so long as the commodities boom is still on, the correction may not evolve into a current account crisis as well, which would force a correction in spending through a dramatically falling currency that makes imports more expensive, as well as exports more competitive.

In Australia's case, if the bust was local and driven by rising rates amidst ongoing high terms of trade, the currency correction would boost commodity profits and keep the Budget in decent shape to cope with falling property-related revenues and a rise in automatic stabilisers like unemployment benefits. It might also mean the Budget is in some sort of position to lend assistance to the banks.

It would also provide relief from Dutch Disease.

Importantly, the RBA has been at pains to point out that much of the resources boom is being financed outside of the banking system so any credit crunch may have only a marginal effect on the resources investment boom.

There might be some danger of an inflation breakout but it would surely be mitigated by the dent made in consumption arising from the negative wealth effect.

Perhaps, if we were really lucky, high national income could provide support as banks and consumers went through balance sheet repair.

No one would welcome the widespread pain of a housing bust but if you believe it is inevitable then going through it in the middle on an export boom sure as hell is better than one accompanying an export collapse. As Goldman Sachs recently pointed out, in the latter event a financial crisis merges with a current account crisis and you face the likelihood of a depression.


Anonymous said...

As your hits show you, your jottings are read with interest from our side of The Ditch. Given the precariousness of the NZ property market; and the fact that we have set to work on our non-bank lenders balance sheets with gusto!, I can only hope that when our property market likewise corrects, the banks in the 'Lucky Country', our banks,give some measure of economic protection to our country.

Alex Barton said...

Stevens and his team have made some odd decisions. House prices will now almost certainly fall further, but that's not the whole story. Globally, governments and central banks are keeping rates low, devaluing their currencies, and becoming more competitive. The RBA is pulling the wrong way, regardless of the consequences for Australian business. But I think they may have shot themselves in the foot this time. Public pressure is growing for reform, and that might just include reform of the RBA, not just the commercial banks.

Alex Barton
Australian Property Forum

David Llewellyn-Smith said...

Don't think so, Alex. Not till after housing busts. Then a great army of chickens will come home to roost..

homes4aussies said...

You've hit the nails on the head in my view, David ;-)

And I would not be surprised in the least if this is exactly what was said in infamous attachments G & H