Did The Reserve Bank Get It Wrong?

The Age

Thursday March 6, 2008

Tim Colebatch

THE December quarter national accounts confirm that the Reserve Bank is raising interest rates in a slowing economy. Trend growth in spending and output peaked last March. It was hot. It's now cooling.

The figures back up the softer tone the Reserve is using this week, if not its decision to raise rates again.

With minerals prices soaring, the economy overall looks in no danger of collapse. But parts of it will be.

High interest rates hurt those who borrowed more than was safe. They force up the dollar, making local producers and exporters uncompetitive. They sharply cut into housing activity, worsening housing shortages and stress.

But the scary thing lurking in the darkness ahead is the future of the financial sector. We are a deeply indebted country, addicted to borrowing, in a world where borrowers are suspicious and obsessed with risk.

In the six months to January, bank lending to business shot up at an annualised rate of 30%. Why? In this climate, even big companies cannot issue bonds in their own name, but have to ask the bank for money. Investors afraid of the future are selling bank shares, so capitalisation is shrinking.

While the banks can still issue bonds, the premium they pay to do so is up to five times its old level, relative to the rate they pay to borrow from each other. Either they pass that on to you or me, or sharply cut their profits.

If they did that, their share price would plunge even more. To maintain capital adequacy ratios, they would then have to ration lending.We have never been here before. To get here we broke a lot of the old rules, and like kids exploring a deep cave by the sea, we don't know what will happen if a high tide comes in.