‘Warning on nation’s prosperity‘ reads the front page headline in today’s Financial Review. Long-time readers of Markets and Money know that we’ve been warning about this for some time.
The headline is in response to a report by the Treasury’s ‘top economic forecaster‘ David Gruen, who said Australia faces a sharp slowdown in the growth of national income, a surge in age-related government spending demands, and a squeeze in revenue from the high dollar and lower commodity prices.
That’s a nasty economic cocktail that we face. So what’s going on?
The biggest change that Australia faces over the next decade is a material slowing in national income growth. Over the last 20 years or so, real national income growth was 2.7%. During the height of the China boom in 2010/11 (when coal and iron ore prices were sky high) real income growth was running at nearly 6% per annum. That’s an extraordinary pace of growth.
But now, on the other side of the boom, Treasury forecasts long term income growth of just 1.1%. In the short term, we think even that might be a little optimistic.
Why? Well, the strong growth achieved over the last decade was a direct result of the historical high in the terms of trade. That is now in the process of unwinding. Only high iron ore prices are keeping the terms of trade from falling dramatically. And only continued stimulus-led growth in China is keeping iron ore prices high.
But for how long can China keep it up? Yesterday’s flash manufacturing PMI, which seeks to give an early gauge on manufacturing activity for the month of November, came in below expectations at 50.4 (versus estimates of 50.8). Our guess is that the index is again heading toward contraction with a reading below 50 over the next few months.
China is just managing to keep its head above water at the moment. This year’s rapid credit growth is showing signs of slowing down. If this is indeed the credit tide going out, then it will expose a lot of naked swimmers.
This has happened before. Credit growth slowed in 2012 but the authorities weren’t prepared for the consequences. So they allowed the shadow banking system to provide credit, which turned out to be an unprecedented boom.
Here we are 12 months later and China is on the cusp of another slowdown. Are the authorities serious about economic reform and the short term pain that this will bring? The statement from the third plenum suggests they are. This week Fang Xinghai, an official with the Central Leading Group for Financial and Economic Affairs, said at a conference that ‘one or two small or medium-sized banks’ may go bust as a result of growing liquidity risk. We haven’t heard such rhetoric before.
Wanting economic reform and pulling it off are two separate things. But we’ll repeat what we’ve been saying about China for some time; genuine reform and economic rebalancing won’t come without pain.
If China does experience a sharper than expected slowdown in 2014, Australia’s terms of trade will fall harder than expected, as will our national income. It may even go backwards.
This will put more pressure on the budget, which shouldn’t be surprising because that’s how the cycle works. You’re meant to produce surpluses in the good years and deficits in the bad years. Needless to say, Australia hasn’t done that.
The reality of lower long term income growth means Australia is now looking at increasing the eligibility of the age pension to 70 years, amongst other measures. And RBA governor Glenn Stevens is again talking the dollar down. Overnight, he took a leaf out of the northern hemisphere central bankers’ playbook, mentioning that currency intervention was a part of the central banks’ ‘tool kit’.
Stevens needn’t have bothered. There are only two things that will take the Aussie down convincingly. Firstly, ‘tapering’ by the Fed, although the timing on this is uncertain. Secondly, a slowdown in China, unopposed by the government, would knock a good 5 cents off the Aussie/US dollar exchange rate. We think this scenario is simply a matter of time.
So all this means Australia is in for a lean patch for the better part of the next decade. The only thing that we can focus on to improve the outlook is productivity growth. This will require far-reaching changes to our current tax structure, which probably won’t happen until things become much worse.
We mentioned the other day that in such circumstances the government might even look at reviewing the very expensive and very useless tax policy of negative gearing on property. Some Markets and Money readers, however, disagree with us. Here’s a response to our musings on negative gearing from PL (with our comments in parenthesis)
‘Your newsletter is the only thing on the www which I subscribe to, so no offense is meant in my remarks. I look forward to it every day. (No offence taken. Proceed…)
‘Greg, you’re like a dog with a bone on this subject.
‘You must ask yourself sometime – ‘given that Australia has the highest median income, high personal savings and a very high percentage of homes owned without a mortgage, is there something I’m missing?’ (Our high personal savings are a product of not spending the huge rise in national income in recent years. We don’t have enough savings to sustain our borrowing requirements and standard of living, which is why we rely on foreigners to keep rolling over around $750 billion in debt financing).
‘I think you’re American, no? (Errr…no. Maybe just an ignorant Aussie?)
‘This argument you are making has been a favourite of Australian journalists for as long as I can remember (a long time).
‘It never ever gets off the ground because every politician knows it will likely be his last decision. (Which doesn’t mean it’s wrong. We care about good policy for this country, not about whether politicians will vote for it or not based on their own self-interest).
‘It is the culture of the country and obviously it results in a more fair distribution of wealth. (C’mon, seriously?)
‘Every Aussie knows that the sharks live mainly in the world of equities and that they could lose all their wealth overnight if they were all in equities. (Wherever there is easy money there are sharks. People mistake sharks for dolphins in real estate because prices have gone up for 20 plus years. Everyone gets a feed so it’s all good. )
‘The bond market is of little interest in a growth environment. Don’t forget Australia is huge, it is under populated (arguably) and it has all of Asia really just discovering it. We will keep growing with occasional blips. (Agree with this, but blips in a highly leveraged economy will seem much worse at the time.)
‘That is if the pollies don’t sell us out like they have in the USA.
‘On another point, since when did the reckoners worry about the government missing out on revenue from private transactions? (We don’t. We just suggested that under budget pressure, the government might do something drastic like reassess NG.)
‘What would happen if negative gearing was removed?
‘‘Who knows?’ as Bill might say.
‘One thing you do know is that the way Australians take personal (and sometimes exciting) responsibility for their own wealth will be disrupted and they will likely be the losers.
‘Your logic has probably cost you exposure to another rally.
‘Believe me, you are floggin’ a dead ‘orse.
‘I’m not buying the gloom on the economy either
‘As you have said, we have high wages. I would have thought this is good as long as unemployment is low, which it is. (Sure, it’s good in the short term, and deserved from the previous decade’s commodity boom. But if it doesn’t come with productivity improvements, then it’s bad for the economy in the long run.)
‘We have historically low interest rates, but this is totally a function of the US Fed’s policies and our need to keep a lid on the exchange rate. There is no end in sight for this scenario.
It is logical that the powers (banks, govt, media etc.) should try to talk down any potential bubbles.
‘We have had an historic boom in mining investment. Presumably this is followed by a boom in mining income. The pipeline of wealth coming from this will spread more widely than during the investment phase I imagine. (Well it hasn’t hit yet. We’re still running trade deficits!)
‘Banks are as tight fisted as they have been in a long time. I think they know that the Northern Hemisphere is a ticking nuclear/financial/social time bomb. But I think they also know that you can’t hold back the tide.
‘Don’t be afraid to dip your toe in Greg, what’s the worst thing that can happen?‘
The worst thing that can happen? How about another 2008 style bust but without the China boom to shield us from the fallout?
Lastly for today, here’s an angry little email from the disaffected AK. He thinks that we should call for the abolishment of all interest deductibility on all investments, not just on property. Otherwise we’re just being hypocrites because we’re some sort of equity market pumpers.
‘What a myopic, self-interested piece you published on negative gearing. The sort of twaddle I hear often. Like so many who choose to comment on economic issues you mix your metaphors as freely as you mix your facts. Its time you clarified something — do you oppose negative gearing on property, investment or both? Your assault on negatively geared property investment as a rort is hypocrisy of the highest order. You seek to carve out a niche for property you do not wish to apply to other asset classes. If you are opposed to negative gearing let’s hear you call for an end to negative gearing of equity portfolios. What’s that? Nothing to say? While you’re at it we should call for an end to tax deductions for interest on business loans too?
‘Like so many others you want to kill negative gearing on property because it’s not in your area of interest or operation. But heaven help anyone who on the grounds of equity in the tax system suggests you should not be entitled to claim a deduction for gearing on your share portfolio. Or is it that you are suggesting a complete exemption from tax for rental properties — no deduction for losses, no tax on profits? I think not. You just want to penalise another sector of the economy in which you do not partake. You’re no better than the other cronies looking for a handout or special treatment. “Take it from them and give it to me.” The elites always call for an end to negative gearing for property. Why? Because it’s the common man who uses it to raise himself up and get ahead. The elites prefer equities — you know, that asset class you spend every waking hour spruiking.
‘So if you’re fair dinkum, call for an end to the deductibility of all interest, and if you don’t have the guts for that keep silent.
Look, we’re having a go at negative gearing because it’s a flawed policy. If it’s a policy to encourage an increase in the housing supply then it doesn’t work. All it does is encourage speculation in the existing housing stock, and those playing the game intentionally make a loss on their investment, which is then subsidised by other taxpayers.
Stop making this about ‘property versus shares’ or some other nonsense. That’s not the point of our argument. We’re arguing for better policy. You, AK, are arguing for the status quo to remain so you can continue profiting from it.
If Australia is ‘fair dinkum’ about it, it would just change the NG rules to apply to only new housing. That would be a far better use of the country’s capital, and may even be a step in improving our very low productivity growth. Remember, productivity is the key to long term prosperity. A 20 year housing boom (backed by rising debt levels) hasn’t improved our productivity performance one little bit.
Have a great weekend…
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