We’re getting worried about China’s impact on Australia and Europe

November 3, 2011

RBA and Interest Rates

While we all try to get our arms around what is actually happening in and market sentiment hangs on the ebb and flow of the noise that is European politics there are longer term structural economic considerations that are slowing bubbling on the back burner and will have material impacts on the global but more particularly Australian economy in the months and years ahead.

The main point of interest for us is what is going on in  China and its economy at the moment. It seems to us that it has taken a step down, or is taking a step down rather and is slowing faster than many appreciate. The latest update of the Chinese Leading Index was released over the weekend, which may account for why it didn’t seem to get any airplay, and it looked terrible.

Take a look at the Leading Index’s sharp deterioration recently – there has been a clear and material deterioration in the leading index over the past couple of months. This suggests to us a substantial further fall in Chinese GDP. The last release of a week or so ago showed Chinese GDP growing at 9.1% against expectations of 9.1%. This leading index to us suggests that this growth rate will fall to 8% which is getting dangerously close to the “hard landing” territory.

Now obviously China is important to Australia and I’ll get to that in a bit but in the global context where Europe is pulling itself apart, or more likely as I read yesterday, Greek Prime Minister Papendreou is doing his best Samson impersonation and pulling the whole house down on him China may also hit Germany hard.

As you can see in the chart above there seems to be a fairly good directional relationship between the Chinese Leading index and German exports with a 6 month lag. Clearly exports look like they are under pressure and with them german growth. Anything that threatens Germany’s growth profile by definition threatens the whole outlook for the Eurozone and any ability or political will to rescue the periphery. We expect a further deterioration in German and EU economic growth to continue to put downward pressure on the EUR and ultimately this in and of itself could derail any EU rescue package in 2012.

But turning to Australia. We all know how important the Chniese economy is to our nation in terms of exports and the RBA keeps reiterating their importantance to us. . Writing over at MacroBusiness back in February I covered the China Australia linkage saying,

Certainly the RBA thinks China is a keyThey are on the record in many different fora as saying this is probably a long boom and although RBA Governor Stevens said just the other day that we can’t be sure how long this boom last they have consistently voted with their interest rate raising feet over the last year or so that it is impacting the Australian economy. But the chart below shows starkly just how important the Chinese economy is now to Australia.

Speaking at the NatStats 2010 Conference back in September 2010 RBA Assistant Governor Phil Lowe said:

These developments in China are being closely observed in Australia, including at the Reserve Bank. A decade or so ago, we spent a lot of time puzzling over why quarterly movements in Australian GDP were so highly correlated with quarterly movements in US GDP. We don’t puzzle over this anymore – not because we solved the puzzle, but because the correlation has fallen (Graph Below). At the same time, the correlation between quarterly movements in Australian and Chinese GDP has steadily increased. Clearly what happens in the Australian economy is now more dependent upon what happens in China than has been the case at any time in our past.

So where China goes, to a significant other extent, so goes Australia

To wit have a look at this chart.

This is one of our favourite charts on the outlook for interest rates in Australia – it is part of our interest rate toolkit because we all know, and the RBA tells us, just how important China is and what a high correlation Chinese growth now has with Australian growth as we showed above. The white line is the Chinese Leading indicator with the purple line the RBA cash rate with an adjustment for the extra points either added on or not passed through from the major banks. Why do we do this? Because it is the rate that people pay not the rate that the RBA charges which is important for monetary policy.

So what do we see?

We see a relationship between the Chinese leading index and the Australian adjusted cash rate that has been improving and strengthening over the past decade – just like the Australia -China GDP growth relationship. We also see that for some time now the leading index has been at level consistent with rates on hold or biased lower. This is one of the inputs into our view for a long time now that there was no need for the RBA to hike rates and why we were one of the earlier groups on the rate cut call bandwagon.

Why are we raising this today you may ask? The key reason is that while we initially thought there might only be one more easing to 4.25% before the RBA rests the update of the index over the weekend gives us pause for thought – rates may need to go much, much lower given the Chinese and European outlooks.


Please remember these are not recommendations for you to trade these are my views and I have my risk management tools and risk parameters that you do not have access to. Thus, this blog is for information only and does not constitute advice. Neither Greg McKenna nor Lighthouse Securities has taken your personal circumstances, objectives or financial situation into account. Because of this you should, before acting on this information, consider its appropriateness, having regard to your objectives, financial situation or needs.

If you do need economic, investment or financial advice we are happy to help.

Please Email the team at Lighthouse at info@lighthousesecurities.com.au or Greg directly on greg@lighthousesecurities.com.au

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