Air From One Bubble Replaces Another

Yesterday we argued Australia’s house-price boom has been detrimental to the long-term health of the economy and our standard of living. Household’s who benefited in the early part of the boom certainly felt wealthier. But credit booms distribute the wealth unevenly.

When booms driven by credit finally end, you’re left with falling asset prices and high debt levels. That’s where we are now in the Australian economy. The long house price boom is finally over. But the debt that drove the price increases still remains.

Which is why the underlying economy feels so weak for so many of us. We’re experiencing the hangover. If not for the mining boom, the headache would be much worse.

Today’s Australian carries the headline ‘Mining hides flatlining economy’. That’s hardly news. But did you know that Western Australia, that great resource state, was actually in technical recession for the two quarters to 31 December 2010? A weak housing market and retail sector, as well as declining business investment, were behind the contraction in growth.

Mining is indeed carrying the economy. It’s the reason behind the RBA’s interest rate rises and the expectation there is more to come, despite the poor underlying health of the economy.

And it’s all because of our booming terms of trade, which the RBA has alluded to in just about every statement and speech concerning interest rates in the past few years.

A rising terms of trade means Australia receives more for its exports relative to what it pays for its imports. The way in which the beneficial terms of trade flows through to our economy and how it affects interest rates and the dollar is important to understand. It has implications for your investments now and will certainly do so in the future when today’s benign conditions change.

The first thing to understand is that a rising terms of trade has a big impact on national income, also known as nominal GDP. While real GDP growth has limped along in a bit of a daze recently, (below 3 per cent growth annualised over the past six months) nominal GDP has been very strong.

In the year to 30 June 2010, nominal GDP was 10 per cent. In the year to September 30 2010 it was 9.6 per cent, and in the year to 31 December 2010, nominal GDP came in at a still robust 8.8 per cent.

The difference between weak real GDP and strong nominal GDP, or national income, is largely due to the strong terms of trade.

A few months ago we asked the RBA for an explanation of how it worked and they came back with the following. It’s a bit on the technical side but if you read it a few times it will make sense.

As you may be aware, nominal GDP measures output in current prices while real GDP measures output in constant prices. That is, real GDP is measured in such a way as to remove the direct effect of changes to prices over the period for which the estimates are complied. Constant price measures for GDP are obtained by linking together (compounding) movements in volumes, calculated using the average prices of the previous financial year (currently 2008/09), and applying the compounded movements to the current price estimates of the reference year.

The difference between nominal and real GDP is called the implicit ‘GDP Deflator’. It is an implicit measure because it is calculated as a residual from the levels of nominal and real GDP. The GDP deflator is somewhat different to the Consumer Price Index (CPI) inflation rate. The implicit GDP deflator relates to a broader range of goods and services in the economy than that represented by the CPI, and measures both changes in price and changes in the composition of aggregate output. In contrast, the CPI is a measure of changes in retail prices of a constant basket of goods and services that is representative of consumption expenditure by households in Australian metropolitan areas.

As highlighted in the November 2010 Statement on Monetary Policy, the strong growth in nominal GDP in the June quarter 2010 was largely driven by a sharp increase in the terms of trade. The terms of trade measures the ratio of export prices to import prices. The increase in export prices for Australia’s commodities have provided a significant boost to the terms of trade. These price effects are reflected in growth in nominal GDP, but not in growth in real GDP, which is measured in constant prices.

As a result, the RBA keeps a very close eye on nominal GDP growth, as this more accurately reflects the short-term surge in national income, which, if left unchecked, could lead to longer term inflationary pressures.

So if you’re wondering why the RBA still seems keen to lift interest rates, look to the terms of trade and nominal GDP growth.

And if you want to know who influences the terms of trade, look to China. As we’ve said before, China is a bubble waiting to burst.

Nouriel Roubini, the man who gained prominence by loudly predicting the US housing bubble years before it burst, thinks so too. In a recent email to clients, he said:

I’m writing on the heels of two trips to China during which I met with senior policy makers, bank executives and academics, just as the government launched its 12th Five-Year Plan, intended to rebalance the long-term growth model. My meetings deepened my own impression and RGE’s long-standing house view of a potentially destabilizing contradiction between short- and medium-term economic performance: The economy is overheating here and now, but I’m convinced that in the medium term China’s overinvestment will prove deflationary both domestically and globally.

Once increasing fixed investment becomes impossible—most likely after 2013—China is poised for a sharp slowdown. Continuing down the investment-led growth path will exacerbate the visible glut of capacity in manufacturing, real estate and infrastructure. I think this dichotomy between the high-growth/inflation pressures of the next couple of years and growth hitting a brick wall in the second half of the quinquennium is far more important than the current focus on a “soft landing” amid double-digit growth. A number of local scholars close to policy circles agree that this is the biggest challenge of the next few years, as we’ve been saying for months.

After 2013 is as good a guess as any. But is Roubini buying too much time? Perhaps being years too early on his US housing bubble call – and enduring the ridicule that caused – is leading him to be too conservative on his China implosion date.

The People’s Bank of China recently raised interest rates for the fourth time since October. The Chinese economy, more dependent on fixed investment than just about any economy in history, is certainly getting closer to a tipping point…perhaps closer than 2013.

Whatever, Australia’s future depends on China. Interest rates will remain where they are until China falters. As long as the terms of trade remain high and national income growth strong, there will be a bias to tighten rates.

That’s why RBA Governor Glenn Stevens is happy to see high savings rates and the rest of the economy in the doldrums. As long as it stays this way, he won’t have to increase rates.

The Australian economy is very unevenly poised at the moment. The air flowing over the ocean from the China bubble is replacing that coming out of the housing bubble. Signs of prosperity persist. But like the Aussie housing market, the China bubble is built on debt, and so will ultimately prove unsustainable.

Meanwhile, the equity market moves relentlessly higher, oblivious to the building risks…

Greg Canavan
For Markets and Money Australia

Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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3 Comments on "Air From One Bubble Replaces Another"

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Harold Christensen

You should check on the input data to WA’s calculations. It is NOT in a recession, the calculation does not include eg mining revenue.


As someone who has recently moved to Australia from the UK, it’s a complete mistery to me how most Australians fail to see how ridiculously overvalued their property market is. I would have thought the coming crash should have been easy to predict given recent events in many other countries. Unfortunately I think it is going to come as a major shock for most people.


The English education system is a complete mystery to many of us. ;)

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