China’s Growth: Can Goldilocks Outgrow Bears? – IMF Paper

The latest IMF working paper analyses the recent growth dynamics in China, evaluating both cyclical positions and long-term growth prospects. The analysis shows that financial cycles play a more important role than traditional inflation-based cycles in shaping the dynamics of growth.

China’s impressive growth record speaks for itself, and the country’s policymakers have won additional accolades for the timely response to the Global Financial Crisis. The Chinese GDP has been growing at the average rate of nearly 10 percent per year in the past four decades. The well-timed policy relaxation supported growth in the immediate aftermath of the crisis. Several analysts pronounced the arrival of a goldilocks economy in China—not too hot to fuel inflation and not too cold to slip into recession —and some see a continuation of the stable economic growth as the most likely scenario for China.

A key question is how much of China’s slowdown is temporary (cyclical) versus long lasting (structural). Growth fluctuations in developing and emerging markets often follow a pattern of spans of impressive growth followed by long periods of stagnation. The concern is therefore not only about a cyclical growth slowdown typically experienced by mature economies, but a prolonged slump so often experienced in emerging markets. These fears are also fed by the observation that structural ‘imbalances’ in the Chinese economy—exceptionally high investment rates associated by some with ‘forced savings’ —have further grown since the GFC, reducing investment efficiency and total factor productivity (TFP) growth.

Headline growth in China has slowed from the pre-GFC peak of 14 percent to less than 8 percent in 2013. China benefitted from the pre-crisis global expansion, but its export-based model suffered a blow when global demand collapsed. At the same time, the authorities embarked on a massive credit-cum-investment stimulus, which cushioned the impact of the global slowdown.

China-GrowthThe paper simulates theoretical convergence growth paths by substituting China’s data to two versions of the estimated model. The actual growth path for China is significantly above the convergence path simulated from the full model (‘low convergence path’) and is oscillating around the Asian Tigers’ path (‘high-convergence path’) since the dismantling of the strict central-planning system in 1979.

In summary, the paper contributes to the ongoing growth debate by identifying the cyclical position and assessing the degree of potential output slowdown in China. The main results are:

  1. Expect growth to slow down in the near-term. Financial cycles in China play a significant role in shaping growth dynamics, and the economy is now likely near the peak of a powerful cycle propelling the economy since the GFC. An adjustment is therefore both likely and needed to bring the economy closer to equilibrium.
  2. Potential growth is slowing. This is expected as China makes progress on the long journey of converging to advanced economy income levels. As it moves closer to this technology frontier, growth will continue to slow. However, the pace of convergence, and thus China’s medium-term growth rate, will depend on structural reforms. With success in implementing reforms, China can follow the historical experience of other fast-growing Asian economies.

Currently, the ‘finance-neutral’ gap—a measure of the financial cycle—is large and positive, reflecting imbalances accumulated in the economy since the Global Financial Crisis. A period of slower growth is therefore both likely and needed in the near term to restore the economy to equilibrium. In the medium term, growth will slow as China moves closer to the technology frontier, but a steadfast implementation of reforms can ensure that China follows the path of the “Asia Tigers” and achieves successful convergence to high-income status.

Note The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

Effects of Income, Fiscal Policy, and Wealth on Private Consumption

An IMF working paper discusses an important issue, relating to what should have been the appropriate fiscal policy in the aftermath of the global financial crisis is very much open. There is considerable controversy over the impact of fiscal consolidation on economic activity and on why sluggish economic growth persists across many advanced economies several years after the onset of the financial crisis.

This paper looks at private consumption because, on average across countries, it is the component of GDP that accounts for the largest proportion of the overall changes to real GDP. Using econometric modelling the paper looks at the possible effects of fiscal policy on private consumption, but also explore the negative wealth effects stemming from the collapse of housing and financial assets in the context of high household debt. They argue that wealth effects played an important role weighing down consumption growth, suggesting that the effect of fiscal policy on economic activity may be overestimated if such factors are overlooked.

Two interesting data sets relating to the relative position of Australia and other countries in the analysis which shows the relative significance of private consumption in Australia since 2003. In the context of slowing income growth and very high household debt levels today, we cannot expect households to create significant GDP momentum in the next few years. Yet we have been very reliant on this for some time. In essence we have a structural economic problem.

IMF-Consumption-2 IMF-Consumption-1More generally they find that consumption is impacted by wealth effects, in addition to fiscal policy. They find a significant long-term relation between consumption and the different components of income and wealth. Labor income remains the main driver of consumption. Personal income taxes and social security contributions are found to have a negative impact on consumption, while social benefits are found to have a larger positive impact. Financial assets and housing assets are found to have a positive coefficient, while household debt is found to have a negative coefficient. Furthermore, the results suggest that the contribution to consumption from an increase in financial or housing assets would be more than offset if financed fully through in increase in household debt.

Note that IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

China Policy Shift Prioritises Growth Over Debt Problem – Fitch

Fitch Ratings says the Chinese government directives last week concerning local government debt signal a potentially significant policy shift to prioritise growth over managing the country’s debt problem. Uncertainty over the scale and strategy to resolve high local government debt remains a key issue for China’s sovereign credit profile, and the latest directives could reflect a continuation of an “extend and pretend” approach to the issue. The directives should be credit positive for local governments, while broadly neutral for banks.

A joint directive from the Chinese finance ministry, central bank and financial regulator on 15 May, instructed the banks to continue extending loans to local government financing vehicles (LGFV)s for existing projects that had commenced prior to end-2014, and to renegotiate debt where necessary to ensure project completion. This is an explicit form of regulatory forbearance, and serves to delay plans to wind down the role of LGFVs. More broadly, it also suggests that propping up growth in the short term has temporarily taken priority over efforts to resolve solvency problems at the local government level.

Fitch estimates local government debt to have reached 32% of GDP at end-2014, up from 18% at end-2008. The CNY14.9trn increase accounts for 18% of the rise in total debt.

The authorities’ efforts to rein in indebtedness have led to a squeeze on monetary conditions and credit that has dampened growth. GDP expanded 1.3% qoq in 1Q15, and April activity data indicated the slowdown has persisted into the second quarter with weak demand across the board. Fixed-asset investment growth slowed to 12% yoy for the first four months of 2015, a 14-year low. Property investment growth fell to 6% from 8.5% in March as China’s 2009-2014 real estate boom continues to unwind.. This poses downside risk to Fitch’s projection of 6.8% growth for 2015.

Earlier, on 13 May, the central government also announced a USD160bn debt swap plan by which local governments would be allowed to convert LGFV debt for municipal bonds and where the bond yields would be capped.

For local governments, the swap will ease the interest burden at a time when a slowing economy and a significant reduction in land sales are weighing on revenue growth. Local government debt often carries interest rates in excess of 7%, whereas the local bonds that will be converted from debt under this programme will be restricted to yields not in excess of 30% above central government bonds with similar tenors.

Fitch views the development of a local bond market as credit positive in itself for local governments. They will benefit from an extended maturity profile on the bonds compared with LGFV instruments. This will significantly reduce liquidity risks, and ensure a better asset/liability match. It also widens local governments’ funding channels and builds a more transparent fiscal reporting system.

More broadly, Fitch expects the resolution of China’s debt problem will ultimately involve sovereign resources, and that debt will migrate on to the sovereign balance sheet. The agency views the debt-swap plan as part of this process, even though the new local government debt is not expected to carry an explicit sovereign guarantee – as the debt is likely to be perceived as having a strong implicit guarantee. Nonetheless, the expectation of substantial contingent liabilities is factored into China’s ‘A+’/Stable sovereign IDR, affirmed in April 2015.

For Chinese banks, the shift from debt to bonds will affect profitability, especially as the rates on the swapped bonds are being capped. Banks will receive lower yields on the same exposure at a time when net interest margins are coming under pressure owing to the macroeconomic slowdown. Furthermore, the government directive to continue extending loans to LGFVs on certain projects will have a negative effect on banks’ liquidity and leverage. More broadly, the directive highlights that banks remain subject to direct influence from the authorities, which could have an impact on management governance and standards.

However, it also reinforces the role that state banks play in economic stability, and therefore the high likelihood that they will benefit from state support. Furthermore, the impact on liquidity will be offset somewhat by the fact that banks will be able to use municipal and provincial bonds as collateral to access key lending facilities. This will enable them to boost lending to higher-margin business. Notably, too, the conversions should have some positive impact on banks’ reported capital ratios as municipal bonds have lower risk weights than local government loans.

ASEAN Financial Integration – SME Funding Needs

Interesting speech from Mr Muhammad bin Ibrahim, Deputy Governor of the Central Bank of Malaysia (Bank Negara Malaysia), at the ASEAN Risk Conference. The 10 countries which together are defined as ASEAN, make up a large and fast developing economic area with 600m people, and it could be the fourth largest trading bloc by 2050. But the credit gap for SMEs in East Asia is estimated to be more than USD250 billion, due to under-developed financial systems. Cross regional financial services players could have a critical role to play in future growth and development.

The vision for an economically and financially integrated ASEAN represents the aspiration of many policy makers, old and new. A recent take on this can be found in a document titled “The Road to ASEAN Financial Integration”, a study on the financial landscape and formulating milestones on ASEAN monetary and financial integration. This document endorsed by the ASEAN Central Bank Governors and approved by the Finance Ministers presents a clear, ambitious and committed statement by the region to collectively embark on this journey. In this respect, ASEAN has made meaningful progress in the identification, articulation and implementation of principles to advance financial and economic integration among its members.

ASEAN is home to more than 600 million people and if considered as a single entity, would represent the sixth largest economy in the world with a combined GDP of USD2.5 trillion. According to the OECD, the region is projected to sustain an average annual growth of 5.6% over the next four years and is expected to be the fourth largest trading bloc by 2050. Concurrently, the standards of living among the general populace will continue to improve. Household purchasing power has risen significantly over the last decade, transforming the region into a thriving hub of consumer demand. The size of ASEAN’s consuming class is expected to double from 81 million to 163 million by 2030. By 2020, Asia is estimated to account for more than half of the total global middle class population, with ASEAN representing more than USD2 trillion of additional consumption within the region.

Also, as the sources of economic growth become increasingly domestic-based, this enables many economies to diversify their sources of growth. An important development is the significant increase in intra-regional trade. These developments augur well for the region and would expand domestic demand and further fuel greater intra-regional trade among ASEAN member countries.

The promise of higher living standards and employment is also drawing large numbers of people from the countryside to cities. Today, just over a third of ASEAN’s population are living in urban areas. This is expected to rise to 45% by 2030.

Integrating national financial systems within the region is key to unlocking ASEAN’s enormous economic growth potential. As a critical component of the AEC, financial integration will significantly enhance the efficiency and effectiveness of intermediation and allocation of resources. This is crucial as the region pursues greater economic prosperity that is both inclusive and sustainable. By allowing the region’s financial resources to move more freely across borders, financial integration will open up new opportunities for businesses and trade, enhancing further financial linkages within the region.

A more integrated regional financial system would also allow a larger share of the region’s surplus savings to be deployed within the region towards productive ends, such as in physical infrastructure projects. According to the Asian Development Bank, ASEAN will require approximately USD1 trillion 1  over the next 10 years in infrastructure investments across the region. This includes for the provision of sufficient housing, efficient public transportation and access to clean water and electricity. While the numbers seem staggering, the ability to recycle the huge savings within ASEAN will substantially enhance the region’s prospects to fund and sustain such investments.

With one of the highest savings rate in the world, at approximately 30% of GDP which currently amounts to USD750 billion, a well-integrated regional financial system would provide a more comprehensive eco-system for an efficient and competitive intermediation and investment.

An important component of ASEAN growth is the critical role of SMEs in all economies. The AEC recognise this and calls for SMEs to play a greater role in contributing to the overall economic growth and development of ASEAN as a region. Access to financing, however, remains a key challenge for many businesses. Despite various national level efforts, more needs to be done for SMEs to obtain access to financing, including the funding required to grow their business beyond national borders. The credit gap for SMEs in East Asia is estimated to be more than USD250 billion.  The difficulties in access to financing are compounded by underdeveloped financial systems, the need to manage multiple banking relationships across different markets, and a lack of coordinated financial advisory support to help businesses navigate the regulatory and business environment in different jurisdictions. A larger presence of regional financial institutions can significantly reduce these challenges. Banks with wide regional networks would possess the intimate knowledge of each economy and understands the unique requirements of SMEs. Such banks are well placed to serve and harness SMEs’ capability to participate more meaningfully in the region’s production networks.

For ASEAN financial institutions, the prospect of regional financial integration will also serve to raise industry standards across the region. This includes enhancing the breadth and quality of financial products and services as a result of more efficient markets and the transfer of knowledge and technology. Financial institutions will also need to meet higher standards in how they manage risk and govern their operations. To some extent, this will be driven by regulatory efforts to elevate prudential and business conduct standards. But aside from regulation, greater economies of scale and scope will also make it more feasible for financial institutions to invest in talent and more advanced technology and systems, to support business development and risk management.

Chair Yellen Says US Rates Will Rise, Slowly

 In a speech by Fed Chair Janet L. Yellen at the Providence Chamber of Commerce, Providence, Rhode Island, she outlined the state of play of the US economy. Whilst there are mixed signals, she affirmed that rates will begin to rise later this year.

Implications for Monetary Policy
Given this economic outlook and the attendant uncertainty, how is monetary policy likely to evolve over the next few years? Because of the substantial lags in the effects of monetary policy on the economy, we must make policy in a forward-looking manner. Delaying action to tighten monetary policy until employment and inflation are already back to our objectives would risk overheating the economy.

For this reason, if the economy continues to improve as I expect, I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate target and begin the process of normalizing monetary policy. To support taking this step, however, I will need to see continued improvement in labor market conditions, and I will need to be reasonably confident that inflation will move back to 2 percent over the medium term.

After we begin raising the federal funds rate, I anticipate that the pace of normalization is likely to be gradual. The various headwinds that are still restraining the economy, as I said, will likely take some time to fully abate, and the pace of that improvement is highly uncertain. If conditions develop as my colleagues and I expect, then the FOMC’s objectives of maximum employment and price stability would best be achieved by proceeding cautiously, which I expect would mean that it will be several years before the federal funds rate would be back to its normal, longer-run level.

Having said that, I should stress that the actual course of policy will be determined by incoming data and what that reveals about the economy. We have no intention of embarking on a preset course of increases in the federal funds rate after the initial increase. Rather, we will adjust monetary policy in response to developments in economic activity and inflation as they occur. If conditions improve more rapidly than expected, it may be appropriate to raise interest rates more quickly; conversely, the pace of normalization may be slower if conditions turn out to be less favorable.

Oil Prices And Their Economic Impact

How will lower oil prices flow through into inflation, growth and economic activity? Will monetary policy need to adjust to take account of oil price movements, or should these short term movements be isolated from inflation targetting? All important questions.

In a speech given today to the AIECE Conference in London, Martin Weale, External member of the Monetary Policy Committee, discusses two key issues for the inflation outlook in the UK: the impact of oil price moves on the UK inflation forecast, and the degree to which international prices feed through into the outlook in this country.

Weale’s arguments derive from models he believes offer a more realistic sense of the probability of relatively extreme movements in prices occurring than implied by more popular methods in economics – a lesson economists should have learned from the financial crisis. He states: “It might seem like a technical point, [but] it is in fact fundamental: if you seriously underplay the chance of relatively extreme events happening, then not only will you be more surprised when they do happen, but you may be tempted to read too much into them.”

Weale’s model for the impact of oil prices on the macroeconomy – drawing on long run data beginning in 1970 – indicates there is a risk that the impact of the oil price fall we have witnessed will be somewhat stronger in the near term than the MPC has predicted. The result, he concludes, would be that growth for 2015 would prove a little stronger, and inflation a little weaker, than expected.

However, Weale states that the risk of a slightly weaker profile for inflation has little impact on his outlook for policy, as the effect will have dissipated within two years – the relevant point for policymaking.

Turning to the international context, Weale investigates how far inflation in the UK is determined independently of what happens in other advanced economies.

Weale notes that the correlation between inflation in the UK and other OECD countries has been relatively high since 2008 – and more so over the past eighteen months.

However, he finds that there is relatively limited statistical evidence that the correlation is strong over the longer-run. Using data from 1993 to the present, he notes that the variability of core inflation in other rich countries can account for only about a seventh of the variability of UK core inflation.

Summing up, Weale states that the MPC must weigh the need to respond to these international factors, against the desire to provide some stability in the level of interest rates and output.

He adds: “I think the Committee is quite right to let the short-term effects of external shocks feed into inflation, even if this pushes it far from target, whether on the downside as now, or on the upside as in the crisis. To do otherwise, and tighten or loosen aggressively, would do little to help inflation in the short term, but would risk a lot with unwanted gyrations in output.”



Federal Reserve Minutes From April Suggest Rates US Rates Will Be Lower For Longer

From the Fed: Information received since the Federal Open Market Committee met in March suggests that economic growth slowed during the winter months, in part reflecting transitory factors. The pace of job gains moderated, and the unemployment rate remained steady. A range of labor market indicators suggests that underutilization of labor resources was little changed. Growth in household spending declined; households’ real incomes rose strongly, partly reflecting earlier declines in energy prices, and consumer sentiment re-mains high. Business fixed investment softened, the recovery in the housing sector remained slow, and exports declined. Inflation continued to run below the Committee’s longer-run objective, partly reflecting earlier declines in energy prices and decreasing prices of non-energy imports. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Although growth in output and employment slowed during the first quarter, the Committee continues to expect that, with appropriate policy accommo-dation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual man-date. The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2 per-cent over the medium term as the labor market improves further and the transitory effects of declines in energy and import prices dissi-pate. The Committee continues to monitor inflation developments closely.

To support continued progress toward maxi-mum employment and price stability, the Committee today reaffirmed its view that the current 0 to ¼ percent target range for the federal funds rate remains appropriate. In de-termining how long to maintain this target range, the Committee will assess progress—both realized and expected—toward its objectives of maximum employment and 2 percent inflation. This assessment will take into ac-count a wide range of information, including measures of labor market conditions, indica-tors of inflation pressures and inflation expec-tations, and readings on financial and interna-tional developments. The Committee antici-pates that it will be appropriate to raise the  target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that infla-tion will move back to its 2 percent objective over the medium term.

The Committee is maintaining its existing pol-icy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions. When the Committee decides to begin to re-move policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run

Latest RBA Minutes Deliberately Gives No Forward Indication

The RBA released their board minutes from the Monetary Policy Meeting held earlier in May. They continue to balance generally weaker indicators with the risks of stoking the housing market in Sydney and Melbourne with a rate cut. They also agreed that, as at the time of the reduction in the cash rate in February, the statement communicating the decision would not contain any guidance on the future path of monetary policy.

International Economic Conditions

Members noted that growth of Australia’s major trading partners had eased a little in the early months of 2015, but was forecast to remain close to its long-run average in 2015 and 2016. Minor revisions to the outlook largely reflected weaker growth in China in the March quarter, which had also been reflected in lower bulk commodity prices and hence a slightly lower terms of trade than previously forecast by staff. Monetary conditions remained very accommodative across the globe and low oil prices were also supporting growth of Australia’s trading partners. Core inflation rates were below central banks’ targets in many economies.

Economic growth in China had eased further in the March quarter across a broad range of indicators. The Chinese property market had continued to be a source of weakness in the economy and represented a key source of uncertainty for the outlook, both through the effects on demand for industrial products and on the finances of local governments that relied on land sales to fund infrastructure projects. Members noted that residential property prices had continued to fall, albeit at a more gradual pace, and sales were lower than in the previous year. Chinese demand for steel had eased and had been accompanied by a fall in Chinese iron ore production and relatively flat imports of iron ore, although Australian iron ore exports to China continued to grow. Members noted that the authorities had introduced several measures to address the overhang of housing supply, while the People’s Bank of China (PBC) had lowered the reserve requirement ratio for banks.

Although the prices of iron ore, thermal coal and oil prices had rebounded somewhat from recent lows, members observed that the slowing in the growth of Chinese demand for steel had contributed to declines in the prices of bulk commodities since the start of 2015. As a result, the terms of trade had declined and were expected to continue doing so as lower spot prices gradually fed their way into contract prices for commodities, including liquefied natural gas (LNG). Notwithstanding this, members noted that the forecast terms of trade were considerably higher than they had been prior to the mid 2000s.

Growth in the US economy had moderated in the March quarter, largely reflecting the temporary effects of disruptions related to severe weather and industrial action in West Coast ports. Over the same period, conditions in the labour market had continued to improve. Non-farm payrolls employment had continued to grow strongly over the past six months and the unemployment rate had declined further. The Federal Open Market Committee (FOMC) had indicated that it was likely to begin the process of normalising interest rates in the second half of the year as long as economic conditions continued to evolve as expected.

Growth in the Japanese economy looked to have been modest in the March quarter and there were signs that tight labour market conditions were generating stronger wage growth. In the rest of east Asia, growth of both exports and domestic activity appeared to have slowed a little in the March quarter. Economic activity in the euro area had continued to recover gradually over past few months.

Domestic Economic Conditions

Members observed that the forces underpinning developments in the domestic economy were much as they had been for some time. The available data suggested that growth in the domestic economy had continued at a pace a bit below average in the March quarter. Members noted that growth was expected to continue at a similar pace over the coming year before picking up gradually to an above-average pace over the course of 2016/17.

Household consumption growth had picked up late in 2014 and recent indicators were consistent with expectations that consumption would continue to rise gradually, supported by very low interest rates, relatively strong population growth and a gradual decline in the saving ratio. Members noted that if households respond to very low interest rates and higher asset prices to a similar degree as they had in the period prior to the global financial crisis, expected outcomes would include a lower saving ratio and higher consumption growth than embodied in the forecasts. Alternatively, if households were less inclined to bring forward their consumption than had been factored into the forecasts, perhaps to limit the increase in their leverage, consumption growth would be likely to be weaker and the saving ratio higher than forecast.

Conditions in the established housing market had remained strong in Sydney and Melbourne. However, across the rest of the country, which accounts for around 60 per cent of Australia’s dwelling stock, housing price growth had declined. The available data suggested that dwelling investment had grown strongly in the March quarter, supported by low interest rates and above-average population growth. Forward-looking indicators, including residential building and loan approvals, suggested that dwelling investment would continue to grow strongly in the next few quarters. Members noted that growth of housing credit for both owner-occupiers and investors had remained relatively stable in recent months, with overall credit growth broadly in line with longer-term income growth.

Survey data had suggested that business conditions in the non-mining sector were around average and that business credit had picked up of late. However, forward-looking measures of business confidence had remained a little below average and non-residential building approvals had also been running at a relatively low level. Members noted that non-mining business investment was expected to recover later than had been thought at the time the forecasts for the February Statement on Monetary Policy had been prepared. This reassessment was consistent with the weak reading on investment intentions for 2015/16 from the December quarter ABS capital expenditure survey as well as business liaison by the Bank, which had suggested for some time that businesses would commit to increasing investment only after observing a durable improvement in the growth of demand. Members noted that exchange rate developments were also likely to remain important for investment decisions. Uncertainty about both the timing and speed of the recovery in non-mining business investment remained key risks to the forecasts. Mining investment was still expected to decline sharply, but the speed of that decline continued to be uncertain.

Resource export volumes had grown strongly in the March quarter, in part reflecting the absence of substantial weather-related disruptions across the country. Resource exports were expected to continue making a strong contribution to growth as new production, particularly of LNG, came on line over 2015. Members noted that the capacity to maintain production plans in the face of lower commodity prices had been enhanced by further cost-cutting by producers, and that this had been assisted by the decline in the price of oil (an input into production) over the past year.

Fiscal consolidation by the federal and state governments was expected to contribute to subdued growth of domestic demand over the forecast period. Members noted that the Commonwealth Budget, which would be announced the following week, would provide important information for updating these forecasts.

The most recent labour force data indicated that employment growth had been increasing over the past six months or more, to be a little above the rate of population growth. Members noted that the revised labour force data also indicated that the unemployment rate had been stable through most of this period at about 6¼ per cent, and observed that the extended period of slow wage growth may help to reconcile these data with the below-trend growth in the economy over 2014. Forward-looking indicators of labour demand had continued to point to modest growth of employment over coming months.

Members noted that the delayed pick-up in GDP growth in the revised outlook meant that the unemployment rate was forecast to rise further, before starting to decline gradually towards the end of the forecast period. Wage growth was not expected to increase from current low levels for some time. Members discussed the possibility that employment growth could grow fast enough such that the unemployment rate did not increase, especially if there was ongoing moderation in wage growth.

Inflation in the March quarter had been broadly as expected. CPI inflation had slowed over the past year, reflecting the large falls in fuel prices and repeal of the carbon price. Underlying inflation had remained around ½–¾ per cent in the quarter and 2¼–2½ per cent over the past year. Domestic inflationary pressures – as indicated by non-tradables inflation – had remained below average, consistent with the extended period of slower wage growth. Inflation in consumer prices related to housing was marginally above its historical average, driven by inflation in new dwelling costs reflecting the strength of the housing market. Tradables inflation (excluding volatile items and tobacco) had picked up in response to the depreciation of the Australian dollar over the past year or so.

Members noted that the inflation forecast had been revised down slightly since February, reflecting the expectation that growth of economic activity would remain below trend for a little longer than previously forecast. Domestic labour cost pressures were expected to remain well contained and underlying inflation was expected to remain consistent with the inflation target over the forecast period. Headline inflation was forecast to remain below 2 per cent in year-ended terms through to mid 2015, before picking up to be consistent with the inflation target thereafter.

Financial Markets

The Board’s discussion of financial markets commenced with the unusual trading in the Australian dollar in the period immediately prior to the announcement of the Board’s decisions in February, March and April. Members were briefed on the Australian Securities and Investment Commission’s preliminary finding, which had been announced the previous day, that each of those moves in the Australian dollar had been a result of ‘normal market operations in an environment of lower liquidity immediately ahead of the RBA announcement’.

Members observed that financial markets continued to focus on the situation in Greece and monetary policy developments in the major economies.

Negotiations between the Greek Government and its official sector creditors remained at an impasse. Greece appeared to have sufficient funds to meet its scheduled payments in May only after the introduction of further stopgap measures. The next Eurogroup meeting was scheduled for 11 May and at least partial agreement would be needed on Greece’s reform agenda before further assistance funds were released. Overall, Greek banks’ reliance on emergency liquidity assistance had increased significantly recently and total Eurosystem lending to Greek banks now exceeded one-quarter of their total liabilities.

Members noted that the apparent deadlock in Greece had had little impact on broader financial markets until recently, when spreads on the debt of other euro area periphery countries – including Portugal and Spain – had increased as concerns surrounding Greek finances continued to rise.

In contrast, yields on German and other highly rated European sovereign debt fell to new lows in April following the continued expansion of the European Central Bank’s balance sheet, with the 10-year Bund yield declining to 8 basis points. In recent days, however, there had been a marked retracement, with 10 year yields rising by more than 30 basis points in Germany and the United States.

In the United States, market pricing continued to suggest that the first increase in the US policy rate could be closer to the end of the year, and the subsequent pace of policy tightening could be slower than that envisaged by members of the FOMC as published in mid March.

In China, the PBC had taken steps to boost liquidity by reducing the reserve requirement ratio. This step had partly sought to offset the reduction in liquidity resulting from sales of foreign reserves by the PBC in recent months. Equity prices had continued to record particularly large rises in mainland China, leading to prices more than doubling since mid 2014. Members noted that the rally in the Chinese share market had coincided with rapid growth in retail financial investments funded by debt, which raised concerns about the sustainability of the rise in share prices and the potential effects of any decline.

The appreciation of the US dollar since mid 2014 had continued its modest reversal over the past month, resulting in a depreciation of the US dollar against most currencies. Reflecting that, together with recent domestic data, the Australian dollar had appreciated by 3 per cent against the US dollar and by 2½ per cent on a trade-weighted basis over the past month. Nevertheless, compared with its level in mid 2014, the Australian dollar remained around 17 per cent lower against the US dollar and around 10 per cent lower on a trade-weighted basis. In contrast, the Chinese renminbi had been little changed against the US dollar over the past month and in trade-weighted terms remained around 12 per cent above its level in mid 2014.

Members noted that equity prices in the major developed economy markets had risen during April, with the exception of Europe, where equity prices fell a little after large rises earlier in the year. In Australia, equity prices also recorded a small decline in April, although the resources sector had outperformed, with energy sector share prices rising following an increase in the oil price.

Corporate bond issuance by Australian entities remained robust in both domestic and international markets amid favourable pricing conditions. In the money market, pricing on money market instruments pointed to around an 80 per cent chance of a reduction in the cash rate target at the present meeting.

Considerations for Monetary Policy

Members assessed that the outlook for global economic growth had been revised only marginally lower in the near term and would continue to be supported by stimulatory monetary policies and the low price of oil. They noted that growth appeared to have slowed in China and that the weakness in the Chinese property market continued to represent a significant risk both for Chinese growth and demand for construction-related commodities. Lower growth in the demand for commodities had contributed to the lower prices of Australia’s key commodity exports since the beginning of the year. As a result, Australia’s terms of trade were expected to decline a little more than was forecast three months ago.

In their discussion of the appropriate course for monetary policy, members noted the revised staff forecasts for the domestic economy. Although the recent flow of data had been generally positive, there had also been indications that future capital spending in both the mining and non-mining sectors would be weaker than expected. Overall, compared with the previous set of forecasts, growth was now expected to take longer to strengthen and the unemployment rate was likely to remain elevated for longer. This change, and generally subdued growth of domestic costs, including wages, implied that inflation was expected to be slightly lower than in earlier forecasts though still consistent with the target. On the face of it, this meant that it would be appropriate to consider an easing of monetary policy.

Members also discussed the potential risk that low levels of interest rates could foster imbalances in the housing market. While concerned about the very strong pace of growth of housing prices in Sydney, and observing that conditions in Melbourne were strong, members saw much more muted trends in other capital cities. As at previous meetings, they acknowledged the risks that could accompany a sustained increase in leverage from already high levels, should that occur, and that the expansionary effects of lower interest rates could be less than in the past. On the data available for this meeting, however, it did not appear that the growth of housing credit, either for investment or owner-occupancy purposes, had been increasing over recent months. The Bank would continue to work with other regulators to assess and contain the risks arising from the housing market.

More broadly, members noted that the low levels of interest rates were helping to support demand in the face of a number of persistent headwinds and that a further reduction in the cash rate would provide some additional support to economic activity by reinforcing recent encouraging trends in household demand. In turn, this would support non-mining business investment insofar as demand conditions were the main factor constraining these decisions. Such outcomes would be expected ultimately to lead to stronger labour market conditions. Members also noted that further depreciation of the exchange rate seemed to be both likely and necessary, particularly given the significant declines in key commodity prices, and that such an outcome would help to achieve more balanced growth in the economy and assist with the transition to a lower terms of trade.

Members discussed the timing of any interest rate adjustment. They could see cases both for moving at this meeting or at the subsequent meeting. The latter course would bring the advantage of additional information on the economy, including details of the forthcoming Commonwealth Budget. On the other hand, with the revised staff forecasts scheduled to be released a few days after the meeting, members acknowledged that the challenges of communication might be more effectively met with a reduction in the cash rate at this meeting.

On balance, taking all these factors into account, the Board decided that the best course was to ease monetary policy further at this meeting. Members agreed that, as at the time of the reduction in the cash rate in February, the statement communicating the decision would not contain any guidance on the future path of monetary policy. Members did not see this as limiting the Board’s scope for any action that might be appropriate at future meetings.

The Decision

The Board decided to lower the cash rate by 25 basis points to 2.0 per cent, effective 6 May.

Sales Of New Motor Vehicles In April

The ABS released the April 2015 sales today. Hard to read the data, as there are some significant variations between the trend estimate and the seasonally adjusted figures, though on both measures Sport Utilities continued to shine.

The trend estimate (our preferred view)  for April 2015 was 95 288, an increased by 0.5% when compared with March 2015. This was the highest April result on record. When comparing national trend estimates for April 2015 with March 2015, sales of Sports utility and Other vehicles increased by 1.9% and 0.1% respectively. Over the same period, Passenger vehicles decreased by 0.4%.

VehicleSalesTypesApril2015 Seven of the eight states and territories experienced an increase in new motor vehicle sales when comparing April 2015 with March 2015. Tasmania recorded the largest percentage increase (1.6%), followed by Queensland (1.1%) and the Northern Territory (0.9%). Over the same period, Western Australia was the only jurisdiction to record a decrease in sales (0.1%).

VehicleSalesStatesApril2015Turning to the seasonally adjusted estimates, the April 2015 seasonally adjusted estimate (94 888) has decreased by 1.5% when compared with March 2015. When comparing seasonally adjusted estimates for April 2015 with March 2015 sales of Passenger and Other vehicles decreased by 8.3% and 0.6% respectively. Over the same period, Sports utility vehicles increased by 7.4%.

Five of the states and territories experienced a decrease in new motor vehicle sales when comparing April 2015 with March 2015. The Australian Capital Territory recorded the largest percentage decrease (6.1%) followed by Queensland (4.8%) and Western Australia (2.8%). Over the same period, the Northern Territory recorded the largest increase in sales (3.2%).

Managing Two Transitions

Philip Lowe, RBA Deputy Governor spoke at the Corporate Finance Forum and spoke about two transitions.

The first is a domestic one – that is, the transition in the Australian economy following a period of extraordinarily strong growth in investment in the resources sector combined with record high commodity prices.

The second is a much more international one – and that is what seems to be a transition to a world in which global interest rates are lower, at least for an extended period, than we had previously become used to.

He explored the impact of low rates:

The first is the challenge that low interest rates pose to anyone who is seeking to fund future liabilities. Low interest rates mean that the present discounted value of these liabilities is higher than it once was. In turn, this means that more assets are needed to cover these liabilities. For anyone managing a long-tail insurance business or a defined benefit pension scheme, this is a major challenge. It is also a challenge for retirees and those planning for retirement.

The second issue is the effect of low interest rates on asset prices. Just as low interest rates increase the value of future liabilities, they increase the value of a given stream of future revenue from any asset. The result is higher asset prices. Another way of looking at this is that faced with low returns on risk-free assets, investors have sought other assets, and in so doing they have pushed up the prices of these assets. A good example of this is commercial property, where investors have been attracted by the relatively high yields, pushing prices up even though rents are declining.

Graph 10: Prime office capital values and rents
A rise in asset prices is, of course, part of the monetary transmission mechanism. But developments here need to be watched very carefully. History is littered with examples of unsustainable asset price rises emerging on the back of perfectly justifiable increases in prices. In a number of cases, this has ended badly, especially if there is leverage involved. Also, we should not lose sight of the fact that interest rates and the returns generated from assets are ultimately linked to one another. So, interest rates may be structurally lower in part because the stream of future income generated from assets is also lower than in the past. This would have obvious implications for the sustainable level of many asset prices.

The third issue is the effect of low interest rates on firms’ investment decisions and hurdle rates of return. In today’s environment, it seems that many investors have, reluctantly, come to accept that they will earn lower yields on their existing assets. An open question though is whether the same acceptance of lower returns is flowing through to firms’ decisions about the creation of new assets – that is, their own investment plans.

The international evidence is that the hurdle rates of return that firms use for new investment are quite sticky and that they are not very responsive to movements in interest rates. There is less evidence of this issue in Australia, but a recent survey of CFOs by Deloitte hints at the same conclusion. The survey results suggest that hurdle rates of return on new investment are typically above 10 per cent and sometimes considerably so. The results also suggest that the average margin between the hurdle rate of return and the weighted-average cost of capital is about 3 percentage points. As part of the survey, firms were also asked how often they changed the hurdle rate, with the most frequent answer being ‘very rarely’. These findings are very similar to those reached through the Bank’s own extensive business liaison program.

Graph 11: Hurdle rates