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Good news from China and elsewhere on interest rates and stimulus spending

06/08/2012 by Alex Carrick, RCD Canadian Chief Economist

The “tea leaves” may have been turning more negative for the world economic outlook of late, but there is plenty of encouraging news nonetheless.

Austerity is the buzz word for government spending almost everywhere, but on the monetary side, the major thrust continues to be nothing but accommodation.

In the U.S., the Federal Reserve has made clear its intention to keep the benchmark federal funds rate near 0.00% until well into 2014.

Plus there is increasing speculation that a QE3 round of quantitative easing may be coming. This would see another large increase in the money supply.

Failing QE3, an extension of Operation Twist is likely. In this scenario, the Federal Reserve will continue to manipulate its bond purchases to lower interest rates over the longer-term.

The intention is to ensure a positive stable environment for risk takers over the next decade.

One of the problems for the economy presently is the aversion to risk taking. Each new snippet of bad economic news sends funds scurrying for the safest harbors – Swiss francs, the Japanese yen and U.S. treasuries.

This is anathema for construction. Building activity is dependent on capital that is willing to accept some risk.

The Reserve Bank of Australia has just lowered its key interest rate. And Australia is an economy that is enjoying strong output growth (more than +5.0% in Q1, annualized).

The head of the European Central Bank (ECB), Mario Draghi, has indicated a willingness to take affirmative action to help the economy. This is primarily taken to mean a lowering of interest rates.

Perhaps most significant, China has just taken more assertive steps to ease credit. The official lending rate has been reduced by 25 basis points (where 100 basis points equals 1.00%) for the first time since 2008.

The benchmark one-year rate is now 6.31%, down from 6.56%.

Furthermore, in an additional extraordinary measure to loosen up credit, individual banks have been given more leeway in the rates they can set.

They will be allowed to offer 20% discounts on the benchmark rate. Plus – and this is where new ground is being broken – they can pay depositors 10% more than the official rate.

The latter is seen as an especially important step to stimulate consumer spending. The tendency in China, due to very low interest rates (and not much of a social safety net), has been for savers to horde their money in the form of cash.

Money hidden away isn’t circulating. It isn’t adding to the reserves that banks can then turn around and put to work as loans.  

China is also quietly taking steps to increase stimulus spending. This is coming in the form of major industrial construction projects.

These plans are important to follow because they will have an impact on world commodity prices, which have fallen into a lull.  

Key resource prices have pulled back from their most recent highs. Oil, copper and iron ore are among the prime examples.

Within the past two weeks, new steel plants have been approved for Baosteel Group (third largest in the nation by output) and Wuhan Iron & Steel Group (fourth largest).

These will be located in the southern environs of the country. The cost is expected to exceed U.S. $20 billion.

The added output will be sold not only to customers in China – with Honda and Toyota as two Japanese carmakers with plants in the region – but also to markets in the rest of Southeast Asia.

There is another key industrial sector in which China appears to be ramping up its planned infrastructure spending.

After the Tsunami-induced disaster at Japan’s Fukushima power plant last spring, the authorities in Beijing declared a moratorium on the nation’s aggressive nuclear station expansion program.

Time has been needed to assess the safety of existing facilities and to ensure that plans for future sites comply with all new standards and requirements.  

China has 14 existing plants. Estimates of the number of new stations planned by 2030 range from 30 to 100.

According to a recent article in the Globe and Mail, China National Nuclear Power Co. is planning an initial public offering (IPO) to raise some of the money for the first block of five new stations.

There is a mandated minimum equity-to-debt ratio for Chinese power projects.

The equity stake at 20% will come to more than U.S. $5 billion. Therefore, the total projected cost of the five new stations will be about U.S. $27 billion.

So what’s happening here at home on the monetary front? To no-one’s surprise the Bank of Canada is holding the line on interest rates for the moment.

The target overnight rate is 1.00% and has been at that level for the past year-and-a-half.

In its most recent press release, the Bank of Canada acknowledged a somewhat deteriorating external environment.

The BOC’s statement reads, “…economic activity in emerging-market economies is slowing a bit faster and a bit more broadly than had been expected. More modest global momentum and heightened financial risk aversion have reduced commodity prices.”

However, unlike some other central banks, the BOC has no inclination to provide additional monetary stimulus at this time.

Its words on that subject are as follows: “To the extent that the economic expansion continues and the current excess supply in the economy is gradually absorbed, some modest withdrawal of the present considerable monetary policy stimulus may become appropriate…”

In other words, the BOC is still leaning towards a rate hike as its most likely first correction rather than a reduction.

This appears to be markedly out of tune with what the rest of the world is singing.  


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