Australia's central bank has the luxury of using Canada as a model writes Chris Rands Portfolio Manager at Nikko Asset Management Australia.
Over the past three months Canada has begun tightening interest rates, delivering two rate hikes in July and September to take the cash rate to 1 per cent.
While this still represents historically low interest rates, the effect of the change will be watched globally given the levels of household debt in the Canadian economy.
We believe it should also garner some attention from the Reserve Bank of Australia, as the structure of the Canadian economy is similar to that of Australia.
From a broad perspective the two economies have similar metrics in terms of GDP per capita, inflation rates and GDP growth.
However, the true similarities emerge in the structure of both economies as parallels can be drawn from the large resource bases and household leverage of the two countries.
Like Australia, Canada is a resource rich country with one key trading partner dominating its trade relationship.
For Canada the key export is oil and approximately 75 per cent of their trade goes to the US, compared to Australia where the key export is iron ore with approximately 30 per cent of exports going to China and over 70 per cent flowing into the Asia Pacific region.
This means both economies are affected by natural resource prices and the demand created by their large and geographically close neighbours.
The second similarity for these economies is that since the early 2000’s housing prices have constantly increased resulting in high levels of household debt. In Australia household debt reached over 120
per cent of GDP and in Canada over 100 per cent.
Both of these figures are above the 90 per cent level where the US peaked during 2008, having increased by approximately 20 per cent since the GFC.
Given this, the International Monetary Fund has been warning both countries that household debt poses risks to their economies and higher debt service costs could slow household consumption.
Despite these similarities, the Canadian economy has been outperforming the Australian economy over the past 12 months.
This has been seen across a number of statistics as retail sales grew by almost 8 per cent year-on-year and GDP 4 per cent yoy, taking the unemployment rate to 6.2 per cent, its lowest level since 2011.
The strength in these figures has enabled the Bank of Canada to begin raising interest rates ahead of the RBA, who are still waiting for stronger data to confirm that the economy is going to meet their expectations.
Due to timing, it allows the RBA to create a resourceful case study on the effects of higher interest rates in an economy with high levels of household debt.
For the RBA, we believe key measures to observe include how consumption and confidence are impacted by higher debt servicing costs, whether housing and construction can remain strong and whether non-mining investment will be large enough to offset the subdued mining conditions.
If the outcome of these observations is that higher rates have relatively little effect, we believe it could embolden the RBA to act more aggressively on the cash rate in the future. If however the Canadian economy begins to show signs of stress over the next 6 to 12 months, then this could cause some concern for the RBA and potentially slow their return to a ‘normal’ rate environment.
While economists can forecast what the effects will be, only time will provide the definitive answer.
Fortunately the RBA has the luxury of allowing that test to be conducted in another economy first.