Why Chinese Growth is Good for Canadian Variable-rate Mortgage Holders (Monday Interest Rate Update)

Dave Larock in Monday Interest Rate Update, Mortgages and Finance, Home Buying, Toronto Real Estate News

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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

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
  • 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.

David Larock is an independent mortgage planner and industry insider specializing in helping clients purchase, refinance or renew their mortgages. David's posts appear weekly on this blog (movesmartly.com) and on his own blog integratedmortgageplanners.com/blog). Email Dave

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