The RBA's interest rate kryptonite

It's now clear that the Chinese comeback that prompted the RBA to raise interest rate six times between October 2009 and May 2010, and then again in November 2010, was unsustainable.
 
It was based on a massive increase in investment rather than any lasting increase in demand, either export or domestic, and China has now found that it can't insulate itself from the rest of the world forever.
 
That 1.75 per cent* increase in the cash rate in 2009-10, while the Fed, the Bank of England, the ECB and the Bank of Japan all left their rates on hold, helped lift the Australian dollar from 65 cents in early 2009 to 110 cents last year.
 
The increase in lending rates for households and businesses, plus the effect of a 70 per cent currency revaluation, knocked the stuffing out of the Australian economy – as intended. The official idea, promulgated in RBA and Treasury speeches, was that the rest of the economy had to weaken to "make room” for the mining boom. Now the mining boom is over, but the stuffing remains out of the economy.
 
Did the RBA make a mistake in increasing rates by 1.75 per cent in 2009-10 while every other central bank played it safe?
 
With the benefit of hindsight, and the fact that the increase will be entirely reversed by Christmas this year, I think we can conclude that it was a mistake. But it did seem like a good idea at the time, let's face it.
 
China was defying global gravity and it seemed as if that could go on forever. Certainly the RBA wasn't alone in coming to that conclusion, with many big global companies pushing the "go” button during this period on a colossal series of big Australian resources projects to take advantage of the apparently endless China boom.
 
The problem is that while the RBA's decisions during 2009-10 can be, and are being, reversed, the capital investment decisions that were also based on over-confidence about China cannot be – in particular the LNG export plants in Queensland based on coal seam gas.
 
Those decisions are now resulting in the highest level of foreign direct investment in Australia's history, which is in turn keeping the Australian dollar stuck above parity with the US dollar despite the 1.5 per cent cut in interest rates, the 10 per cent fall in the terms of trade and, more broadly, the fact that the mining boom is over.
 
In a note last month, ANZ's head of global markets research, Richard Yetsenga, pointed out that the FDI boom has resulted in Australia's first basic balance surplus since the 1970s (the basic balance is current account plus FDI).
 
"This is genuinely a different environment for the Australian dollar. Typically low-yield, current account surplus currencies run basic balance surpluses (think Norway, Switzerland or Japan at one point). For a commodity exporter to do so is almost unheard of.”
 
This morning the dollar is at 102.6 US cents having fallen two cents in two days before and after yesterday's rate decision. But the implication from Yetsenga's analysis is that it is unlikely to keep falling, and certainly won't go back to where it was when the cash rate was last at 3.25 per cent (November 2009, when the dollar was around 90 US cents).
 
Nor will mortgage rates go back to where they were when the cash rate was last at 3.25 per cent. The rate comparison website, RateCity, pointed out yesterday that in November 2009, when the cash rate was 3.25 per cent, the standard variable mortgage rate was 5.7 per cent. Now it's 6.35 per cent although it might come down another 15 to 20 basis points in the weeks ahead.
 
That's a permanent increase in margin between cash and SVR of 0.5 per cent, due to higher borrowing costs in Europe and the contest for deposits in Australia.
 
Little wonder that monetary policy is losing its power – the high dollar and higher bank funding costs are like kryptonite sapping Glenn Stevens' strength. The resources investment decisions made during the great China comeback of 2009-10 are keeping the dollar high and the competition for deposits is keeping lending rates high as well.
 
And no one wants to borrow anyway. Manipulating the price of credit, which is all the RBA can do, is fine when credit is in demand. Now it's like manipulating the price of beef at a vegetarians' picnic.

*This article previously stated that interest rates rose 3.25 per cent over 2009-2010. The actual figure was 1.75 per cent.

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