Australia has enjoyed strong consistent economic growth (over 20 years of expansion), low unemployment and increasing living standards. Its old economy avoided the implosion of the new economy. Its economic performance was underpinned by strong growth in emerging nations, especially China and India, and demand for commodities.
After the global financial crisis, government spending, lower interest rates and a credit-fuelled investment boom in China helped Australia avoid the worst of the economic slowdown in developed markets.
Politicians and policy makers have taken credit for Australia’s strong economic performance, reminding citizens, like former British Prime Minister Harold MacMillan, that ‘they have never had it so good.’
Prime Minister Julia Gillard shared the wisdom of ‘the Australian way’ with leaders from G20 nations. Endorsing the Government’s optimistic economic outlook, shadow treasurer Joe Hockey told The Economist in June 2012, ‘I have no doubt that we are on the threshold of our greatest ever era and the challenge will be managing prosperity.’
But talk about the ‘best performing economy in the developed world’ cannot mask the fact that the economic outlook is deteriorating.
Growth has slowed from 4 per cent plus to around 3 per cent, with further decreases likely. The labour market has weakened. Consumption growth is modest reflecting high levels of consumer debt, and manufacturing output has contracted.
Weakness is driven by a decline in the performance of the mining sector. Terms of trade (export prices relative to import prices) have fallen from historical highs by 10-15 per cent.
Prices for key export commodities, iron ore and coal, are volatile but likely to remain weak. Mining investment, which has underpinned activity, is slowing. Non-mining investment has fallen, with the highest declines in more than 20 years.
In December 2012, the Government admitted that its politically-motivated budget surplus target is likely to be missed. But the real issue is the factors underlying the deterioration of public finances.
Federal government revenues have deteriorated, with cash receipts running below expectations. State budgets are also under pressure. This reflects a slowing economy, which has translated into lower than expected tax revenues.
The scheduled 2013 federal elections complicate budgetary policy. A 2013 budget deficit, which could be as high as $15-20 billion, may increase pressure for further spending cuts that will contribute to further weakness, unless global growth rebounds and exports and investment recover. Alternatively, financing of key initiatives, such as increased funding for education and the national disability insurance scheme, may place greater pressure on the budget.
Australia’s weakening current account is also a concern. Despite the mining boom, Australia’s trade account has been negative for much of recent history. Since 2001, the trade account has averaged a deficit of around $500 million per month, fluctuating between a surplus of $3.4 billion and deficit of $3.2 billion.
In aggregate, the trade account has been in deficit by around $68 billion or around 6 per cent of Australia’s current Gross Domestic Product (GDP). The performance is disappointing given the record terms of trade and strong export volumes despite the need to import capital goods associated with the mining development.
Currently, Australia’s current account deficit is around $50 billion or 3.7 per cent of GDP. It is likely to increase to around 5-6 per cent based on Australia’s weakening export performance, one of the highest in the developed world. It will increase reliance on international financing.
The End of the Commodity Super Boom
The declaration by Federal Treasurer Wayne Swan that talk of the end of the mining boom was ‘claptrap’ had international investors reaching for their dictionaries. But semantics aside, the commodity boom, prophesised by many pundits to go on forever, is slowing down sharply.
The expansion in mining activity in the 2000s was driven by a confluence of demand (unanticipated rapid increase in demand from emerging countries, especially China and India) and supply factors (under investment in capacity reflecting low commodity prices in the 1990s).
Economic growth in emerging markets is slowing, especially in key markets such as China and India. Even if growth levels remain above that in developed markets, the changing composition of growth (a rebalancing from investment to consumption) means that resource intensity will decrease, reducing demand for commodities.
Increased capacity, as a result of aggressive recent investment, will also come on-stream progressively, coinciding with lower demand.
These factors place pressure on commodity prices and also export volumes. It will also drive a slowdown in mining investment. The Reserve Bank of Australia (RBA) now thinks that the peak will occur sooner and be lower than previously forecast.
Projected investment estimates also assume that resource companies will be able to obtain financing for projects. Many miners, especially medium and smaller firms, will have difficulty raising the equity and debt needed due to the weaker conditions.
In the medium term, legacy issues, such as over investment and cost overruns which have created over-priced projects, will hamper Australian resource competitiveness and financial performance. These problems may flow through into financial institutions which have funded these projects.
Even if the weakness in commodity markets is less than feared, the shift from mining investment (plant construction) to operation (production and export) has significant implications.
Construction requires local labour with attendant economic benefits for Australia while operation and maintenance will have less flow through, given high levels of mechanisation and automation.
The resource sector has high levels of foreign ownership with earnings from projects flowing overseas rather than remaining in Australia, limiting the benefits. The high capital cost equates to large tax write offs, depreciation and capital allowances, which means that the tax revenue benefit to Australia may be much less than expected for some time.
Mining also exploits non-renewable resources. Australia has economic demonstrated reserves of iron ore which at the 2009 production rate would last around 71 years. The comparable figures for coal and LNG are approximately 98 years and 61 years. However, this overstates the sustainability of Australia’s mineral wealth.
Low cost reserves are exploited first. As low cost reserves, such as the Pilbara iron ore reserves and Bowen Basin coal resources, are depleted, Australia’s resource competiveness will decrease. This will be compounded by the country’s high cost structures and its poor record in terms of cost escalation, which will encourage investors to look elsewhere.
Weakness in Strength
The appreciation of the Australian dollar has also affected economic performance.
Australian dollar strength reflects higher (until recently) commodity prices. It also reflects the $AU role as an investment proxy for China and safe haven status as one of the few remaining AAA countries.
High $AU interest rates relative to other developed countries drive the risk-on or carry trade. Investors borrow in $US, Yen or Euro to purchase higher yielding currencies, leading to strong capital inflows.
Many of these factors are structural and will continue to influence the currency for some time. The RBA have conceded that a return to significantly lower values is unlikely in the short term.
The higher $AU reduces Australia’s competitiveness in manufacturing, retail, tourism, education and health services, which are all major employers. It has increased imports driven by the cheaper prices of foreign goods. It has increased outflow of capital as investors and firms invest overseas, taking advantage of the strong currency.
The value of the $AU is only one factor determining export competitiveness. Australian manufacturing has been declining for decades. The lack of a large domestic market which allows required economies of scale and scope, distance from markets and lack of unique competences have all contributed to the hollowing out. The ‘golden age’ of Australian manufacturing may have been the product of tariffs, subsidies and trade barriers.
Focus on the $AU masks Australia’s high cost structures, low productivity, poor innovation and indifferent management.
Australian policy makers are now ‘rebalancing’. Lower interest rates are targeted at boosting domestic housing and consumption activity and reducing the value of the $AU. Australia will also rebalance toward Asia.
The RBA has lowered interest rates by 1.75 per cent per annum, with further cuts likely in 2014. But its effectiveness is doubtful. To date, lower rates have had much less effect, relative to previous easing cycles, on consumer and business confidence, labour markets, retail sales, (non-resource) investment and housing.
Given the uncertainty of employment and low-income growth, consumers have a preference for saving, and reducing rather than increasing debt. Savings from rate cuts are being used to pay down debt, limiting the boost to consumption and housing, both of which remain weak. Given low demand growth and overcapacity, lower rates may not translate into increased business investment.
Low rates also create distortions. Reduced income from investments decreases consumption by retirees. It paradoxically decreases spending as savers must save more to meet future needs.
Lower investment income pushes up insurance premiums and also reduces retirement payouts. Low rates artificially lower costs of capital, favouring capital investment rather than employment. Low rates also drive asset inflation and feed bubbles in financial assets.
Low rates can only provide a temporary boost to economic activity. A sustained period of low rates will also make it difficult to increase the cost of borrowing.
Given that artificially low interest rates were one of causes of the GFC, it is ironic that policy makers have adopted the same policy – credit-fuelled consumption and investment – as the solution to the current problems.
Low rates may not reduce the value of the $AU. The ability of the RBA to devalue the $AU is limited given the policies of the US, Japan, Europe and China to weaken their currencies to improve export competitiveness. Given Australia’s reliance on trade and the open nature of its economy, capital controls or other measures to control the $AU are difficult.