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Interest Rates: The RBA's next move...

|Includes: BHP Billiton Limited (BHP)

The challenge of the RBA at their next board meeting on Tuesday 2nd March is to get it right. There can be no errors at this time with the decision and they know this. The reflective comments from the minutes of the last meeting on the 16th February show concerns were predominantly in the area of business lending and employment - two key indicators in our economy that give a high degree of accuracy to the next quarter business activity. When credit is available to fund inventory purchase or capital equipment (or both) that assists in increased production, the flow-on effect is a higher take up rate of labour, consequently more jobs and less unemployment.

Emerging Indicators?

-- Presently, the most recent figures indicate that during Q4 businesses spent money through borrowing to purchase capital equipment. This was mostly in the area of commercial vehicle purchases to take advantage of the government's rebate that expired on 31st December. Some businesses then re-noted these vehicle purchases back to their banks as security in exchange for cash that they then allocated for working capital purposes, thus freeing up capital expended for the vehicle back into their balance sheet to access for inventory/manufacturing use without putting a dent in their cash flow forecast for the following quarter and giving them a tax rebate break.

-- Businesses have been paying down their debt exposure levels over the last 12 months to reduce cost of borrowings and have also been concentrating harder on collecting overdue money from their debtors. This has the effect of capitilizing their balance sheet to 'free up' their capital from the hands of their debtors into their bank accounts, thus reducing the cost of accessing capital for inventory/manufacturing and effectively reducing their debt exposure levels.

-- This is good for business because it means that banks' credit policies will be impacted to a lesser degree with business placing a demand for capital borrowings as the economy begins to grow and gain momentum over the next quarter. In turn the banks will have a lower funding gap to cover between deposits on hand and the costs to obtain the addtional short fall from the wholesale market.

And this is where it becomes interesting...

The Link in Credit Costs...

-- Westpac currently writes 1 in 3 mortgages for the residential real estate market. With the rapid increase in housing purchases over the last 3 years, also assisted by the federal and state governments with the FHOG, the major banks have basically exposed their level of debt security into the housing market. You see, when you extend credit to the commercial market to enable them to trade and stimulate the economy (thereby leading to growth and greater levels of wealth distribution), you are injecting funding liquidity and inceasing the circulation of cash within the economy that results in a higher exchange of goods and services between parties. When we have high levels of credit extended into the residential real estate market, then there is less deposit-based funding available for the commercial community. The commercial community will still require the same level of credit, but now the banks have to go elsewhere to find this cash that they don't have in their deposits from savers like you and I, so they go to the international bill market and buy money from the wholesale market paying a higher price for it than what they can get it for out of their own depositors.

-- This is the reason stated by Westpac, ANZ and most notably, by the CBA, that the funding costs to provide mortgage financing (through accessing wholesales funding) had increased so this is why they put their rates up more than the RBA interest rate rises of last year.

-- When we have a very large slice of our banks' depositors' funds tied up in mortgage financing and the banks are also importing money from the wholesale market paying a higher rate, then when business demand begins to grow for funding from the banks for business expansion to assist the economy to grow, then more money is needed from the wholesale money market, costing the banks more money to provide this to the commercial market. Any move to raise the cost of money in this current environment could not only put pressure on the current business cycle of growth with promise of a consistent local economic recovery, it could also have a 'knock on' effect of stalling the jobs recovery, which in turn adds to the present mortgage stress reported recently amongst the upper working class and would have a direct impact on the banks' funding costs to facilitate a recovery.

-- When banks have a large slice of their funding invested in the residential real estate market, they effectively tie their capital up for an average term of 5 years, over this time, receiving a regular income that generates profits. However, the residential real estate market is only one piece in the entire puzzle that is our economy. The construction and associated 'home market' industries benefit from this, but investment in this market sector has very little flow on into other areas of our economy for which we rely upon to stimulation across a broad business base. So what we have is a huge investment of cash from banks, governments incentives borrowed from tax payers, both accessing wholesale funds at rates higher than what we could normally access them for at home in a business sector that has little broad based influence to stimulate the rest of the economy.

-- In the face of our banks having the majority of depositors' exposure to the residential market, any stall or resistance introduced to the current 'grass shoots' local economic recovery could then have a negative impact on the housing market, which is a major income provider to the banks, reducing thier income through rising mortgage defaults and adding to the costs associated with maintaining the same levels of liquidity in the credit markets to faciliate current ongoing levels of business access demanded to maintain business activity. This would then have an impact upon businesses attempting to fund their activity through credit vehicles at an increased cost...

-- And business would grind to a slow crawl, resulting in something our governments and business activists have been preaching at home would very, very unlikely happen - a double dipped recession.

RBA and it's Rate Dilemma...

-- Now let's go to the unfolding situation in the Euro zone with Greece, (and now Spain) showing signs of red seeping out of their sovereign balance sheets. With Greece revealing debt levels 300% higher in actuality than reported 3 months ago sending the markets globally into a nervous 'shake walk', the meetings of German and French finance ministers along with members of the EU Monetary Committee finding a way to assist Greece a bail out with stringent austerity measures to reduce their debt to around 9% by 2011 (good luck with that!), we now have reports about Spain's debt levels having exceeded the EU's 3% of GDP benchmark condition, necessary to maintain their criteria for inclusion in the EU in the first place. Add to this the countries of Portugal, Italy and Ireland, with market concerns on the same subject, and we have a very high potential situation where major countries in the EU have cash flow problems because of the cost of servicing their debt, having borrowed from the wholesale market.

See the link?

-- The likelihood of these European countries being in the same situation as Greece is extremely likely and means that there is going to have to come from somewhere a large amount of funding to facilitate these countries' debts to continue to be serviced. The alternative is financial meltdown and credit markets seizing in the Euro zone which, of course, would have a very severe impact here. Why? Because everyone knows that we still have 'toxic assets' from the US sub prime disaster which the Fed has taken onto it's own balance sheet in exchange for printing more money to re capitlize the banks to provide credit liquidity into the market. This has meant the funding costs paid by the US banks, from which Australian banks source their funds from, have ultimately increased.

-- With more money having to be provided (actually available currency - meaning more money would need to be printed), the increased demand on wholesale funding and printing money by the ECB would translate back to our banking system as a demand on higher prices being paid for the accessing the same wholesale funding right now. Given that our local mortgage market has about 70% of it's repayments fixed at these fantastic low interest rate levels means that any increase in wholesale funding would NOT be borne by the residentail market, in which the majority of banks deposits are sitting in. Banks would pay a significant portion of the increase in the wholesale costs, passing these directly to existing commercial facilities, increasing the cost of business and ultimately, either flowing into services/manufacturing ( and new house prices, causing a weakening of demand affecting the existing property market ) or profits would be less, creating a micro recession within specific industries, having a wider but less impacting effect upon the overall economy.

-- If the RBA lifts it's rates by 25 basis points as most expect, then this next quarter could be very severe indeed. Let's hope that the RBA very well and in detail, considers it's decision.

Disclosure: None presently.