Australia is being pulled in two directions. Faced with a slowdown in China – the country's biggest customer for resources, such as iron ore – the central bank has decided to promote growth with a cut in interest rates. Yet, that brings new risks. Global investors have been betting on Australia, and high rates have provided an added attraction. Lower rates could scare them away.
Until recently, cutting rates by half a percentage point wasn't really an option. Australia was split into a weak domestic sector and a booming, inflationary resources industry. Cutting rates would have helped the former, but turbocharged the latter, making inflation worse. Now, with China cooling, commodity prices easing and GDP growth at just 0.4 per cent in the last quarter of 2011, inflation has eased to below 2 per cent and the bank is free to act.
There's a complication. Australia's popularity among global investors has made it more vulnerable than most Pacific Rim economies to the ebbs and flows of international capital. Capital coming in from abroad has helped Australia to fund its current account deficit, which could hit 4.6 per cent of GDP in 2012, according to the International Monetary Fund.
Australia has also become accustomed to cheap foreign credit. Short-term offshore loans account for roughly a fifth of all bank lending – equivalent to a tenth of GDP. That is despite a pullback by some European banks, which sucked almost $54-billion (U.S.) out of Australia in the second half of 2011, according to the Bank for International Settlements.
The risk is that lower rates spark more outflows. Even as European money fled last year, other global investors remained attracted to the fact that Australia supplies China with essential resources like iron ore. They were also drawn to government bonds paying two percentage points more than the United States despite a government debt burden less than a quarter the size. But that spread has been narrowing. As rates decline, any turn for the worse in China or Europe could convince foreign investors that Australia isn't the best place to weather the storm.