October 2010

Andrew Pegler – 15 October 2010

With so much talk about interest rates I thought it apt to take a look at some of the basics of the whole shebang.

What’s a central bank?

This is a country’s primary monetary authority. Ours is called the Reserve Bank of Australia, known as the RBA. Other examples include the European Central Bank, the Bank of England and the Federal Reserve in the US. Central banks are busy bees. They issue currency, hold banks’ compulsory deposits and, most importantly for our purposes, set interest rates. Like most rich countries ours is independent of politics so it can’t be dictated to by the PM or anyone else. That way we usually get what is best for the economy, not short-term political objectives like lowering rates during an election campaign.

Who are these people?!

The nine members of the RBA board come from business and academia the board’s only women is Jillian Broadbent AO. They meet on the first Tuesday of every month to work though a few cups of tea and decide to cut, raise or leave rates as is. They do this after taking a good look at the latest inflation figures, economic growth, employment, home loans, building activity and how much people are spending on consumer goods. They also look at what’s going on overseas and how that will affect us. The board members are very smart, they get out a lot.

This is in your interest

As I said, the RBA is our central bank and it – not the government – sets interest rates. There are a few different kinds of interest rates but the one we’re dealing with is called the cash-rate, which is the one that influences mortgage, loan and deposit rates. The RBA uses interest rates to control economic activity. It raises them to keep the inflation genie square in its bottle and drops them to stimulate demand and investment. The principle is that if rates are higher then less people will want to borrow money and therefore economic activity will slow and that means prices slow and that means inflation slows. And vice versa. When they’ve done deciding our fate the RBA sends out a press release outlining the new rate, and why. A few weeks later they release the minutes of the meeting, which are often very revealing about what individual members of the RBA board thought and why.

Hopefully that clears that up.

Andrew Pegler – 24 September 2010

It seems like just a few weeks ago that the dollar was sub USD 90c…hang on that WAS just a few weeks ago!!

Yes folks, the little-dollar-that-could recently surged past .96c in a 26-month high. But, as we have discussed, this comes with benefits and pitfalls. Ahh, such is life.

The AUD has risen more than 17% since May against the US dollar, thanks to a strong domestic economy, a weaker US economy and relatively higher local interest rates in comparison to those in the rest of the world. This creates demand for the AUD, further pushing up its value. The laws of supply and demand again, eh?

The good bits

Get on a plane. Overseas travel is cheaper because a higher dollar means you literally get more bang for your buck. So right now your massage on that idyllic Bali beach just went from not much to hardly anything and it’s time to book in that Easter Island lunar eclipse festival (but avoid the brown mushrooms). Meanwhile imports from iPods to Belgian chocolates and from nuclear submarines to BBQ’s big enough to see from space are also cheaper as the dollar climbs in value compared to other currencies. And, while the RBA doesn’t target a particular exchange rate, cheaper imports tend to keep inflation lower. So that’s a nice win� or is it? According to Glen it ain’t and he’s gone and spoilt the party again with a warning that interest rates are heading up. That cheaper Plasma means nought if you have no home to watch it in because you defaulted on the mortgage.

Piggy in the middle

In the middle are the farmers and the diggers and drillers who get a mixed bag. On the one hand, what farmers produce is less competitive against overseas buyers but on the other hand that American-made tractor has never been cheaper. Meanwhile, BHP and Rio Tinto are more insulated because they sell our dirt in US dollars. But they take a hit when they repatriate their earnings.

The badder bits

The regular currency whipping boys of manufacturing and tourism cop another hammering with the rise of the AUD. Manufacturers who export or compete locally with cheaper imports are squeezed as their product becomes more and more expensive. And the same goes for tourism.

The future?

The other week Bloomberg claimed the Aussie Dollar was the most overvalued currency in the world and with China taking new steps to reign in its property bubble and the bond market starting to waver there is fear in the air, folks, and the herd is getting skittish. That means a potential flight to the USD which will see the Aussie go down and rates to go up – a spiral that could get very ugly, very quickly.

Andrew Pegler – 17 September 2010

For the years leading up to the financial crisis banks across the world had been progressively thinning out how much money they had up their sleeves for the day things turned ugly. As we know that ended predictably but last week the regulators finally struck back.

This stash, known as reserves, is supposed to be pretty heavily policed but pre GFC things were good so no one was really watching. Then the punch ran out, the cops turned off the music, the party stopped and the hangover started and banks everywhere went into meltdown with little in reserve to absorb mounting losses. A response was needed and a room full of bankers in Switzerland called the Basel Committee have delivered it in the form of tough new reserve regulations for banks.

Known as Basel III, the recommendations include doubling the amount of equity capital (the best kind) a bank must hold in reserve from 2% to 4.5% and an extra reserve of 2.5% of their assets called a “conservation buffer”. This buffer can be reduced or increased depending on the economy i.e. rise up to 2.5% if credit is too loose and drop if the economy is tightening. All this means that banks will now have to keep 7% of their equity in reserve in case the wheels come off again. And that’s about double what they had to hold before.

But wait, there’s more! The Basel Committee also added an optional third reserve figure of 2.5% of assets called “countercyclical buffer”. So if credit is expanding faster than GDP, bank regulators can up the reserve requirements to slow credit bubbles and strengthen the banks. Vice versa in a credit crisis – regulators can abolish the buffers immediately and set capitalism free. Nice.

My view? In the glacial-paced world of banking regulations the Basel Committee has done good/played hard. The banking system will be more resilient to larger shocks, less reliant on government support and better able to absorb losses. But let’s not forget this crisis was not about banks missing 1% or 2% of capital. It was about uncontrolled lending that went viral and undetected until it was too late. And then there’s the TBTF (“too big to fail”) problem that none of this addresses. Oh and not having all this coming into effect until 2019 is too long in this fast-paced financial age.

And in other news… Legendary US investor Warren Buffett has ruled out a double-dip recession in America. Da man with the golden touch, the oracle, the seer, the doer. “I am a huge bull on this country,” says Warren. “We will not have a double dip recession at all. I see our businesses coming back almost across the board.” Da Buff has spoken in da buff.

Andrew Pegler – 10 September 2010

Hello readers and Selamat pagi. I’ve just returned from Indonesia where interest rates aren’t the only way they keep inflation under wraps.

As we have discussed before, central banks control inflation by raising or lowering interest rates. Lowering them encourages spending and growth and vice versa. But this hits growth pretty hard and Bank Indonesia (BI), Indonesia’s central bank, has a pro-growth policy so raising interest rates goes against this. So instead BI controls the supply of money to the economy using something called the “primary reserve requirement”. What happens is BI forces Indonesian banks to park a certain fraction of their deposits with it in reserve i.e. a primary reserve requirement. And it can increase and decrease this reserve requirement as it sees fit. The thinking is that this is a neater way to alter the amount of money available for people to borrow without raising interest rates and hence control inflation. This method is not a commonly used monetary policy tool in western industrialised nations but Asian countries like it because it doesn’t hit growth as badly as raising interest rates. And in Asia growth is always the new black. But aside from academic interest, the reason I bring all this up is because right now the BI is worried that Indonesian banks have too much money available to lend to people and it fears this will feed Indonesia’s growing inflation, which just hit a 16-month high. So it has increased the banks’ primary reserve requirement from 5% to 8% of their deposits, sucking out Rp 50 trillion ($5.6 billion) from the economy in one hit. This will slow spending and cap inflation while giving BI the room to delay a rate increase if global growth picks up because, as I said, in Asia growth is always the new black.

One obvious problem I can see in all this, however, is that raising the reserve requirement reduces the amount of money around. And with less money available for people to borrow, it will be more expensive to borrow i.e. rates will go up in line with the laws of supply and demand.

FYI at the moment the Indonesian interest rate is at a record low of 6.5% – ours is 4.5%, the US’s is close to 0% and the UK’s is 0.5%. Also the BI targets an inflation rate of 4-6% while the RBA is a more sober 2-3%. The difference reflects the fact ours is a more developed economy.

Terima kasih banyak readers!