High risks ahead

A combination of tight credit and higher interest rates could put the Australian economy in some peril by the end of the year.

Add the usual risks – as big spending politicians try to buy votes in this year’s elections – and the situation starts to look like a powderkeg.

You don’t have to take our word for this. The Reserve Bank, itself, has issued the grimmest of warnings, over what could happen, if a credit crunch and higher rates arrive together.

And that ugly prospect looks much more likely now than it did, a few weeks ago, when a senior Reserve Bank economist, Jarkko Jaaskela, wrote a paper, warning of this risk.

Don’t forget, either, that the Treasury Chief, Ken Henry, has bluntly warned Australia’s politicians, that reckless, pre-election promises do, indeed, have financial consequences.
Over recent days, the sub-prime mortgage crisis in the US has unsettled financial markets throughout the world. The impact was immediate. Credit risk is now attracting a substantially higher price than it was, just a few weeks ago.

As non-tradtional lenders in Australia, like RAMS, raise the money they lend to home-buyers in these markets, there will, certainly, be flow on effects here. RAMS and similar lenders have been big operators in the Australian market. So some tightening in credit, at least, is now certain. An outright credit crunch is also a distinct possibility, if other lenders, like Australia’s once risk averse banks go back to their old ways and start rationing credit again.

There could well be another interest rate rise this year, too. The Reserve Bank now expects Australia’s inflation rate to stay close to its 3 per cent red line over the year ahead. And the bank’s Governor, Glenn Stevens, has been sounding a lot like John Wayne lately.

“A man’s gotta do etc….”

Higher rates and a credit crunch, together,could well have drastic effects. Indeed, Jaaskela warns, they could produce an “asynchronous response.”

Those words might well become as famous, in the months ahead, as that Iraq war euphemism, “collateral damage.”

As Jaaskela, himself, explains an “asynchronous response” could involve a great deal of financial pain, for Australia’s debt laden families.

“When the growth of credit is below the critical threshold level, interest rate movements are more potent,” he says.

A graph he produced suggests that the public would be forced to cut its spending very sharply, if a credit crunch and higher interest rates arrive together.

Mr Jaaskela is even prepared to use the dreaded R word, in this context.

“There is some empirical evident supporting the idea that recessions are likely to be periods when borrowers’ balance sheets are weak and the availability of credit is tight,”

That’s economist talk for “watch out.”

See www.rba.gov.au