There has been much discussion in media about the Australian banks’ reactions to the Reserve Bank’s increase in the official cash rate to 3.75% on the 2nd December. The broad thrust of comment is that Westpac is being ‘unfair’ in raising their interest rates further than the level of the official rate rise. The other banks moved to also lift their rates but following the immediate response to Westpac, the  lifts weren’t quite as large.

So, what was the fuss about? The official rate rise was 0.25%. Westpac lifted their home mortgage rates by 0.45%, CBA by 0.37%, ANZ by 0.35%. NAB came out with the trump card, signalling their rates would only increase by the official rate rise – 0.25%. The argument is that the banks have enjoyed a “honeymoon” period through the global financial crisis, in which they were supported by the Australian Government guarantee, allowing them to raise more funds, cheaper than they may otherwise have been able to achieve. It seems that there was a catch to this – in return, the banks are expected to be socially responsible with their rates on offer to the community. Excuse me while i laugh. The banks have been building their empires with great glee during this financial crisis, and have been acting in all of the ways that mainstream media say that they shouldn’t. For example, they have used some of those new funds to help pay for purchases of businesses that they want or competitors who don’t have their clout.

While it is good to see the negative reaction to the banks’ increases in lending rates, the underlying story is far more complex than the discussion would have you believe.

One of the reasons that Australia made it through the GFC so well was the fact that most mortgages in Australia are variable, and therefore any drop in official interest rates is likely to impact directly on the bottom line of the average mortgage holder. So, when the RBA reduced rates at a frantic pace over the last year, it directly helped to reduce funding costs and increase available cash for the average consumer. This helps flow through to the rest of the economy, helping economic activity. However, it seems that the bulk of hte funding that Australian banks obtain to help them make all of those loans is actually rather short term – and so they have a need to continuously go out and find new lenders to borrow from, just to keep the loan books that they have in place now. One of the fears during the depths of the GFC was that Australian banks would not be able to obtain that funding. Fortunately, Australia’s employment and house prices stayed strong during the crisis, which allowed Australian banks to look more and more credit-worthy than their international peers. Add in the Government guarantee and suddenly the ability to obtain funding improves dramatically.

The folk in the backrooms of the banks are now casting their eyes over the global landscape and can see that their elevated position is quite possibly only a temporary thing. The global banking system has survived – it is bruised and battered but it is still there. The huge global banks are slowly getting their feet back on firm ground, and will eventually become more competitive against Australia’s banks.

There is also likely to be greater and greater competition for the savings dollar globally. Countries all around the world have instituted massive rescue and stimulus programmes in an effort to keep their major institutions afloat and to protect their businesses. To do this, most have borrowed money, and huge amounts of it. The US is moving to a $12 Trillion dollar debt level. The cost of the bailout of those institutions in the US is equal to 25.8% of GDP (or $10,000 per person). The UK is materially worse – its bailout cost is 94.4% of GDP or $50,000 per person! The BBC has a great graphic on the impact of these deficits. It also shows the huge drop in wealth in those countries – reflected in the drop in house prices and share prices.

And just what are some of those drops in prices? The Australian Financial Review (AFR) has a little note on page 15 today (Thursday 10 December ’09) that suggests US homes have fallen in value by only $500m in the year to November 30… They seem to have had a bit of an error in transmission there… here is the blog entry at Zillow.com (the source). It confirms that the figure is actually 489 BILLION in the last 11 months! The website suggests that this is good, as it is better than the $3,600 BILLION that was lost in home prices in 2008. That is an awful lot of lost buying power.

So what is my point?

It is that the debts being raised by Governments around the world to bail-out their economies and financial insitutions won’t reach its peak for another year or two or three. That means that the competition for the savings dollar will only grow bigger and more intense. That pressure will most likely display itself in the form of interest rate rises. It becomes a double-whammy. The Australian banks will be operating in a market where they will have to pay more and more for the dollars that they source globally. The rates that they pay will have less and less to do with domestic issues and more and more to do with global availability of cash, and this means that the banks will have trouble staying within the official cash rate – which is obviously far more domestically focussed. And so it is likely that the angst against banks has only just begun. Extend this scenario a bit further and you can see that the higher interest rates could conceivably work to reduce local property and share prices. This is not a sure thing – as property and share prices can (and have) continued to rise previously even in the face of interest rate rises. It’s just that this will place even further pressure on banks and make their risk managers even more nervous.

This is not all doom and gloom, as the interest rate rises are nothing more than a return to ‘normal’ after central banks previously reduced rates to artificially low levels in an effort to keep economies going. It’s one of those conundrums of the credit crisis – as the Australian economy bounces back the central bank will need to bring rates back to normal or risk inflationary outcomes and asset bubbles. However, it is a tricky job, as those rises could kill the recovery and send the economy back into a fall. This is not as likely in Australia as it is in the US and UK but it remains a worry for the central bankers here nonetheless.

The issue that is agitating global commentators at the moment is the huge US and UK debt (predominantly) and the difficulty that governments will have in not only repaying that debt but even servicing the ongoing interest costs. This is where the whole interconnectedness becomes messy – and helps to explain why forecasting is now definitely in the realm of ‘Tea-Leaves Finance’. As unemployment stays high the ability of government to raise taxes falls. For example, Bloomberg suggest that personal income tax collections in the US fell 27.5% in the second quarter compared to a year earlier. That makes repaying debt much, much harder. They also suggest a bit of good news, in that the falls in revenue seem to be slowing.

There are also various issues in the debt world that are making all financiers a bit nervous at the moment. There is the issue of Dubai’s debt (which really wasn’t too much news, as they already were poorly rated for credit worthiness) and Greece’s issues in tackling its debts. The worry is that entire countries may default on their debt, which would send siesmic waves throughout the financial world. The huge US and UK debts have some people worried about the devaluation of these currencies and the likelihood of rampant inflation. To protect themselves against such eventualities, some of those folk have been buying the traditional hedge – Gold. And so gold has hit record levels. Australia has benefitted, as we export quite a bit of the shiny stuff. Problem with that is our currency tends to reflect global interest in the products we have on offer. In other words, the speculation on increases in gold (and commodities) lifts our dollar, resulting in a reduced benefit for Australia from these price rises. Here is an example in a graphic – while the gold price is at a record in $US terms, it is far from the record in Australian dollar terms (our peak was back in February).

That currency flow can be seen from a chart prepared by the RBA speech delivered by Guy Debelle (Assistant Governor Financial Markets) to the Westpac Research and Strategy Forum in Sydney.

The key point here is that the bulk of the movement in the Australian dollar occurs from overseas trading. In effect, we are relative minnows at moving our own currency (an outcome to be expected but nevertheless interesting to see in actual trading figures).

The financial world will shift and gyrate as economic growth tussels with interest rates, currencies, credit worthiness, credit availability, unemployment, asset prices and the regulatory environment to end up with some sort of trend or outcome on interest rates for Australian borrowers. My guess is that Australia will simply have to take what it is given or what it can get. We are simply too small at the global level for control of final interest rates to be within our full control.