In our previous article, RBA?s interest rates dilemma, we mentioned that

While those heavy in debt would welcome RBA?s interest rate relief, there are still many unresolved complications.

In that article, we explained why any slashing of interest rates could contribute to price inflationary pressures on the Australian economy.

Today, we will talk about another issue that can complicate matters for the RBA- the pullout of foreign capital. Remember back in Understanding the Balance of Payments, we explained that

Let?s say there is a deficit in the Current Account i.e. Australian dollars is flowing out of Australia. What will happen to the Australia dollars overseas? Since they are useless in foreign countries, they will have to eventually make their way back to Australia to be ?parked.? That means buying up assets in Australia. The converse is true if there is a Current Account surplus. Thus, in theory, the Current Account should balance with the Capital Account.

As it is well known, Australia’s persistent Current Account Deficit (CAD) puts us closer in league to a banana republic (by this measure, the United States is the biggest banana republic). To finance our CAD, money has to flow back in via the Capital Account through the selling of Australian assets. This fact is manifested in the situation of what we described in Can falling interest rates and rising mortgage rate come together?,

A large fraction of Australia?s borrowed money is sourced from overseas through the ?shadow? banking system. In other words, there are not enough domestic deposits to fund all the needed credit (e.g. home loans) in this country.

Now, let’s put yourself in the situation of say, a rich Arab investor with plenty of cash (US dollars). Previously, when Australia’s short-term interest rates were high and rising and the Australian dollar was appreciating, it was pretty good to convert your US dollars into Australian dollars and park your money in an Australian term deposit. The biggest risk for you is that the Australian dollar may depreciate, resulting in a loss as measured in terms of US dollars.

Today, we have a rapidly falling Australian dollar and a RBA signalling its intention to cut interest rates. What will you do? Obviously, you will want to pull out your money from Australia as soon as possible. If the other foreigners are thinking the same, you can expert further downward pressure on the Australian dollar, which will increase the pressure for more foreign money to pull out of Australia. This is going to be a problem for Australia. As a nation, we are dependent on foreigner’s credit to lend us money. If they withdraw their credit en masse, Australian borrowers are going to find that the price of money will increase.

So, if the RBA cuts interest rates too aggressively, it may trigger further falls in the Australian dollar, which in turn will trigger a further rise in price inflation and cost of credit, which in turn will have a very severe impact on the Australian economy. This in turn will trigger even further cuts in interest rates, resulting in the next round of vicious cycle.