Why Chinese Growth is Good for Canadian Variable-rate Mortgage Holders

Last week’s big news was that China clocked a Q4, 2012 GDP growth rate of 7.9%. This was significant because it reversed a seven-quarter decline in that country’s growth rate. (By comparison, China’s Q3, 2012 GDP growth rate was 7.4%.)

From a Canadian variable-rate mortgage perspective, it can be argued that strong GDP growth in China combined with continued weak GDP growth in the U.S. might just be today’s ideal scenario. Here’s why:

• Weak economic growth in the U.S. will ensure that the U.S. Fed maintains its 0% policy rate for the foreseeable future. This will severely limit the ability of the Bank of Canada (BoC) to increase its comparable overnight rate (on which our variable-rate mortgages are based).
• Strong Chinese GDP growth will ensure that commodity prices remain high because China has been the world’s marginal buyer of commodities since it joined the World Trade Organization in November 2001. Our economy is still largely commodity based and as such, the Loonie tends to move in the same direction as commodity prices (although its recent strength has been underpinned by other factors as well). Because a strong Loonie acts as a headwind in provinces that rely heavily on manufacturing and exporting to the U.S. (like Ontario and Quebec), higher commodity prices will also (indirectly) limit the BoC’s ability to increase its overnight rate.

If Canadians tend to overlook the significant influence that China’s GDP growth rate has over our own economic momentum, it’s probably because we engage in very little export trade with the Middle Kingdom. But China’s role as the world’s most voracious buyer of commodities should not be discounted. Many Canadians are surprised to learn that there is now an 85% correlation between the TSX and the Shanghai index. That’s more than double the correlation between the TSX and U.S. equities over the past two years, and also more than double the correlation between the TSX and the Canadian economy.

China’s latest GDP result supports the view that the Chinese economy has achieved a soft landing, but that could change quickly. Here are my two biggest areas of concern on that front:

• While China’s GDP growth rate is impressive, roughly 50% of China’s total GDP is spent on capital investment (buildings, roads, bridges, dams, etc.). After many of these infrastructure projects are completed they sit idle, and as such are not yet contributing any lasting benefit to China’s economy. While capital investment can certainly help stimulate a country’s GDP growth over the short term, governments that rely so heavily on it over longer term periods must perpetually increase capital investment to maintain their GDP growth rates. That’s why history is littered with countries that went broke employing similar strategies, and their capital investment ratios never got close to reaching 50% of GDP. China’s massive, centrally planned economy may be able to use capital investment to defy gravity for longer than any country that tried a similar approach in the past but even China can’t keep building empty cities forever.
• China’s biggest customers (the U.S. and Europe) are mired in what many believe is a long-term economic slowdown and as such, China can no longer rely on export-led growth to assure its long-term economic prospects. Instead, China must focus on developing the vast but still nascent potential in its domestic economy. That’s easy to say, but this transition will take time and for a country that prioritizes political stability over all else, it will be messy. China needs to grow its middle class in order to create consumers with rising disposable incomes. But middle classes also demand more political freedoms and have a historical habit of using revolutions to secure them. China’s leadership wants to move cautiously as it grows its middle class but if it cannot replace its falling export demand with rising domestic demand quickly enough, it risks a sharp economic slowdown – and high unemployment rates also have a habit of fomenting revolutions. China’s continued economic success will require a delicate balancing act.

Five-year Government of Canada bond yields were one basis point lower this week, closing at 1.47% on Friday. More lenders raised their five-year fixed rates last week but sub-3% rates are still available to well-qualified borrowers who know where to look.

Five-year variable rates are available at prime minus 0.40% (which works out to 2.60% using today’s prime rate). While the BoC’s repeated warnings about imminent overnight rate increases are designed to dissuade borrowers from opting for a variable-rate mortgage (more on that in a future post), for the reasons listed above I still think that today’s variable rate may well prove, as it almost always has, to be the cheapest option over the next five years.

The bottom line: If China continues to grow its GDP at a torrid pace, it will give our economy an effective hedge against continued U.S. economic weakness. Such a scenario will effectively tie the BoC’s hands and from a strictly interest-rate perspective, create an ideal scenario for variable-rate mortgage borrowers.