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Central bank plays a different hand Down Under

With Australia's central bank deciding last week to throw in the towel and cut interest rates, can the Bank of Canada be far behind in tomorrow's interest rate announcement?

Sure it can.

There's a temptation to lump Canada and Australia together in the same economic bin. Both are mid-sized, export-oriented economies that have a high exposure to commodity markets and are highly sensitive to the global economic cycle.

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But let's not overstate the common ground here. Both the Australian economy and its monetary policy are in a very different place than Canada's – and their risks to the downside are potentially greater.

Canada's gross domestic product grew at an estimated 1.8 per cent year over year in the just-completed third quarter; Australia's grew at a 3.1-per-cent pace. Canada's inflation rate was an estimated 1.3 per cent; Australia's, 1.8 per cent. Canada's unemployment rate sits at 7.3 per cent; Australia's is 5.1 per cent.

The Bank of Canada's policy rate has been at 1 per cent for the past two years, after being raised gradually from 0.25 per cent during 2010. The Reserve Bank of Australia has cut its policy rate five times in the past year, after jacking it up to 4.75 per cent in 2010.

While both central banks have an inflation target as their primary policy focus, the Reserve Bank of Australia's target is higher – it has a target band of 2 to 3 per cent (a midpoint of 2.5 per cent), compared with the Bank of Canada's 1 to 3 per cent (midpoint of 2 per cent). In practice, that means the Australian authority generally needs to be more stimulative than its Canadian counterpart to maintain inflation near the middle of its higher target band. Given equal circumstances, Australia would be cutting rates sooner.

But as the economic data show, the circumstances of the two banks have been far from equal. And the difference maker can be summed up in one word: China.

China is Australia's single biggest trading partner, accounting for 27 per cent of its exports last year. Australian exports to China have more than tripled in less than five years. (Canada's exports to its biggest market, the United States, are still below their pre-recession levels.)

That has helped keep Australia's economy turbo-charged, and its interest rates well ahead of the rest of the industrialized world.

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But China has become a very sharp double-edged sword for Australia. A Chinese slowdown – which has become increasingly evident in the past year – threatens to pull the rug out from under Australia's economy, much more so than those of Canada or other commodity-heavy nations.

That is most evident in Australia's massive mining sector. Credit Suisse recently noted that China's seemingly insatiable appetite for Australian-mined metals has spurred such a massive expansion in mining that capital spending in that sector now equals nearly 6 per cent of Australia's GDP – double where it was four years ago.

It amounts to a mining bubble that, if it bursts, could drain away Australia's growth. That's a danger that the Reserve Bank of Australia has to worry about – and act upon – that the Bank of Canada does not.

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