Oh Ken Henry! You are tempting fate, Sir. To paraphrase an old saying, those whom the investment gods destroy, they would first make euphoric.
In today’s Markets and Money we’re going to literally take a big step back and explore the unexamined and dark underbelly of Australia’s resource boom: the sustainability (and nature) of Chinese resource demand. Why?
Well, we have a case of nerves, to be honest. Maybe it’s too much caution, but the last week has reminded us a lot of June 2008. So it seemed like a good idea to go back and, painful as it is, examine the mistake that everyone made in not seeing the crash in commodity stocks last year. We don’t want to make the same mistake twice, even if it means making a new mistake we’re not aware of yet.
Make no mistake about it, commodity stocks did crash hard last year. Shares give you leverage on the upside. But when that leverage disappears, they can come crashing back to earth faster than you expect. This is what happened last year. The collapse of resource share prices outpaced the decline in commodity prices. There was arguably no sector of the market (except maybe listed property trusts) that was hit harder.
It could happen again. It’s something we aim to avoid. But judging by the euphoric tone of comments in the press, people are forgetting that it DID happen last year. So why are they potentially making the same mistake?
Well, maybe they aren’t. Maybe we’re assuming the future is going to be some slightly different version of the past. But the big mistake everyone (your editor included) made last year was having binders on about how much the credit bubble had leaked into both commodities futures (driving prices up) and into China’s resource demand.
Many people were right to point out the bubble in U.S real estate and in stocks, bonds, and just about every other asset class on the planet. But when it came to resources, most analysts made an exception for the resource sector. The argument was that while everything else was floating on a sea of credit, there was a bedrock of Chinese and Indian demand for commodities which underpinned the Aussie resource market and resource share prices.
Hakuna matata, mate!
That’s the same argument being advanced today. And while it is undoubtedly true that resource demand for industrial growth in China and India is growing at mammoth rates, no one is asking if this demand itself is a function of loose monetary policy. If it is – and here’s the important point – Aussie resource shares are just as vulnerable now to a big correction as they were in June of last year. That’s why we’re taking up the subject.
It’s a timely subject, too. China’s GDP chugged along at 8.9% in the third quarter. The big driver for GDP growth was massive growth in fixed asset investment. It grew by 33.4% in the first nine months of the year, according to China’s National Bureau of Statistics.
But the meat of the story is that urban fixed asset investment in primary industry – the kind that consumes huge quantities of Aussie exports – was up a whopping 54.8% in the period. This is China’s vaunted stimulus in action. And as you can see from the chart below, China’s import volumes are headed off the charts this year, although the effects of the stimulus are petering out (which could be ominous).
The Chinese government unleashed a $600 billion stimulus spending spree on shovel-ready projects last November. That alone would lead to soaring commodity imports. But because China pegs its currency to the U.S. dollar, its monetary policy must match the Fed’s. That means China’s monetary policy has been every bit as loose and stimulative as Ben Bernanke’s in the last year.
For example, UBS reports that new lending in China reached a record US$1.27 trillion in the first nine months of this year. This kicked off rallies in Chinese stocks, real estate prices, and construction. It also alarmed at least some Chinese officials that their dollar peg forces them to import inflation from the U.S., which can be politically destabilising. So now, they are walking themselves back from the ledge.
In yesterday’s Financial Times, Qin Xiao, the Chairman of the China Merchants Bank (the country’s sixth-largest bank) wrote that the government should not be afraid of a moderate slowdown in the economy. He wrote that, “Monetary policy must not neglect asset-price movements,” he writes. “Therefore it is urgent that China shifts from a loose monetary policy stance to a neutral one.”
Just how Chinese central planners aim to do this is unknown. Can they be neutral as long as they peg? When you peg your currency to keep your exports cheap – because industrial production and exports drive your growth which keeps employment full and the population from getting restless – it’s hard to be neutral when the Fed is anything but. But that subject – when it’s in China’s interests to allow its currency to appreciate – is a whole other subject for another week.
For today we’d only like to make the point, or raise the possibility, that this decades-long China boom Ken Henry is counting on may be a lot more fragile than he thinks. Is there any reason to believe economic authorities in China are smarter than their buddies in Europe and America? All of them seem to be reading from the same play book. Inflate, stimulate, spend, build…and leave the bill for later.
China’s officials have a difficult proposition: industrialise an economy of 1.2 billion people. No one knows how much of that urban fixed asset investment actually contributes the nation’s capital stock, or whether it is more excess productive capacity or bad investment designed to keep GDP charging along.
If it’s not driven by market forces, odds are there’s going to be a huge amount of waste and corruption. And eventually, once the stimulus is removed, Aussie resource producers may find the demand they took for gospel was a function of the credit bubble too. They will have geared up for production increases only to find that the demand has vanished along with the credit that supported it.
But don’t tell that to Ken Henry. He sees four long-term “structural implications” because of India and China’s demand. In his speech yesterday in Sydney he said that, “I have spoken about the structural implications for the Australian economy of their strong contribution to the global demand for mineral commodities. That demand has supported a considerably higher level of our terms-of-trade.”
By the way, Henry says that Australia will run a higher level of terms-of-trade for years. This means the country will get paid more for what it exports and pay less for what it imports. This is a preliminary first-strike on current account deficit hawks. Henry says the current account deficit will rise because of the improving terms-of-trade and that the Australia will import capital because investment will exceed savings.
We don’t want to get into it too much in a confined space, but this is an argument worth having. America ran a massive current account deficit. Alan Greenspan blamed excess savings in the developing world for fuelling the surplus in America’s capital account. He claimed that foreign investors were happy to pour savings into the U.S. stock and bond markets because it was a better investment.
This surplus in the American capital account kept interest rates low. The housing bubble began to inflate. Household savings rates fell. Spending increased. And at the end of the day, the current account deficit blew out. Americans financed a leveraged boom with foreign money and now have to pay the piper.
Henry says not to worry because Australia will import capital for “investment.” That’s all well and good if it’s real productive investment. But as far as we can tell, Aussie banks are importing foreign capital and pumping it right back into commercial and residential housing, blowing an even bigger property bubble. Meanwhile, Aussie households are encouraged to take on more debt, reduce savings, and believe nothing’s amiss here.
Time will tell if Henry’s right. After all, by itself, a current account deficit is not evil. But it is pretty odd that a country that prides itself on its exports runs a trade deficit. Importing the capital that gets deployed in your economy isn’t a sin either. But if you plow it all into a property bubble, it’s a disaster waiting to happen.
But let’s not be too troubled about deficits today. Henry says that, “It would be reasonable to consider that, while the Global Financial Crisis has taken some of the heat out of our export prices, we should get used to the idea that we could have structurally higher terms-of-trade for quite some time – possibly for several decades.” He says this, among other factors, could lead Australia to a period of “unprecedented prosperity.”
And the euphoria? Henry concludes that, “The Australian economy has just demonstrated to the rest of the world that, for some time now, it has quite possibly been the best governed, most flexible, most resilient of all industrialised economies.”
Maybe he’s right. We wouldn’t mind it if he was. But pride goeth before a fall. And there is a real question in our minds about whether the Chinese growth model that’s fuelling demand for Aussie resources – driven, as it is, by credit and the stimulus – is sustainable. We’d argue that it’s not. But that is long argument which we’ll save for next week.
for Markets and Money