Australia’s extraordinary failure

Leave a reply

When I started this blog, I was well aware that its dominant theme was to be the stark divergence emerging between key sectors in the Australian economy: On one hand, the terms of trade were crashing, declining resource investment was primed to rip a hole in domestic expenditure, and Australia’s poor international competitiveness was inhibiting the revival of investment in non-resource tradable industries. On the other hand, we had the cyclical upswing centred on the Sydney and Melbourne property sectors, which policymakers hoped would boost consumer spending and employment growth. Whichever sector gained the upper hand in the short-term, I argued, would determine the next move in interest rates.

As we know, the army of professional forecasters was wrong; the RBA cut interest rates in February this year. Partially as a result of this, the sectoral divergence in the Australian economy has reached truly deformed levels of late.

I say partially for a couple of reason. Firstly, Australia’s external shock has gathered pace quicker than I anticipated (and as anyone who’s read this blog can attest, I’m about as bearish as they come on Australia’s terms of trade outlook!) The relentless slide in iron ore and coal prices (iron ore especially, of course), has hit national income hard and added urgency to the miners’ cost-cutting drive, which directly reduces household income. Furthermore, the oil price bust has hammered the economics of Australia’s gold-plated LNG projects, and ushered in a new emphasis on austerity in that sector as well. These trends are exacerbating the divergence in the economy on the structural side, and are obviously unaffected by Australian monetary policy.

Moving in the other direction with disquieting rapidity is the boom in the East Coast property markets, Sydney’s in particular, which has shifted into a higher gear following the latest stimulus from the RBA. Pick any measure you like; Sydney property is white hot. Auction clearances have soared, investors are increasingly dominating new mortgage issuance, and price growth has rebounded to around 14% from a year earlier.

The property boom on the East Coast is undoubtedly being juiced by lower interest rates. But I believe it is incomplete to assign more than partial responsibility to the blunt tool that is the RBA’s cash rate.

The economy needed low interest rates, and it needs lower ones still,mainly to further reduce the value of the Australia dollar. As national income recedes with the terms of trade, and as resource investment winds down, unemployment will rise sharply unless we can revive activity in non-mining tradable sectors. This is not a lazy ‘competitive devaluation’: Australia had a very strong currency during the boom, and now that the boom has passed it is imperative that the value of the currency falls to match our lower national income and support employment. (Recent falls against the USD are welcome but on a broader basis, particularly against other commodity currencies, there is work to be done.)

So interest rates had to fall to reduce the value of the Australian dollar and repair our international competitiveness, but in so doing they’ve stoked a dangerous boom in property prices (which, incidentally, is a drain on productivity and so worsens our international competitiveness).

To overcome this apparent paradox, the RBA, in tandem with APRA, should have implemented regulatory controls to stifle speculative mortgage lending, especially when funded by offshore borrowings, before embarking on the latest easing cycle. That they did not, so soon after property bubbles ripped apart numerous developed economies, is a blemish on Australia’s economic policymakers. That they were dismissive of such options well into the boom is a serious indictment. That they finally started talking about macroprudential tools 6 months ago, was something of a relief… And that they still haven’t implemented the mooted controls with any bite, at such an advanced stage of the boom, is frankly an extraordinary failure.

Not only has this failure to act sowed systemic risks into the economy at about the worst possible moment, it is also seriously hindering the restoration of Australia’s international competitiveness; there are now strong indications that the RBA will have to hold off cutting interest rates for fear of fueling the rampaging property leviathan. From Peter Martin this on Friday:

Concern about the Sydney property market is shaping as an impediment to another interest rate cut at the Reserve Bank board’s next meeting in April, encouraging it to postpone the decision until May, a week before the federal budget.

A month of two more with an extra 25bps on the cash rate is not going to rein in the investor frenzy. Only rate hikes or a tough macpru regime has only prospect of success. Does the RBA want to sacrifice the wider productive economy to calm the passions of a property investors, or would be it preferable to slap tough, targeted regulatory impediments on the industry and carry on with the post-boom adjustment of lower rates and a lower Aussie dollar?

Australia’s boom in one chart

Leave a reply

Since the turn of the millennium, as the composition of Chinese demand became increasingly dominated by state-directed investment spending, China has accounted for roughly 85% of the increase in world steel output. In nominal terms, this drove Australia’s iron ore export earnings up 15-fold between 2004 and 2014.

This boom has peaked, and indeed, as I pointed out a number of times last year, current levels of steel production in China are only being supported by strong growth in exports; domestic consumption actually declined 3.4% last year, to 738.3 million tonnes.

Although the growth in Chinese steel demand has crested (unless the government decides to reverse its policy stance and announces a big stimulus program), I also see little chance of it falling precipitously in the near future. But this lack of growth in output still presents a big challenge. We simply aren’t going to see the billion tonnes of annual Chinese steel demand by the end of the decade that was conventional wisdom until very recently. This means that iron ore producers are fighting over a shrinking pie and iron ore prices will continue to slide, I would say for another two years at least.

Who’s man enough?

Leave a reply

By now it will be clear to anyone with even a passing curiosity in such things that the Strayanomics view on interest rates, more or less its raison d’être last year, was confirmed on Tuesday.

Well done, team.

The obvious question now is will the RBA cut again? The answer is yes, and perhaps quite soon, depending on employment figures this week. My expectation would be for the RBA to hold at 2% for some time, but next year we’ll see further cuts as the contraction in mining investment bites, iron ore continues to batter national income, and the last hurrah for the housing market draws to a close.

It’s going to be very interesting to see where the cash rate finds a floor. I imagine it’ll largely depend on the value of the Aussie dollar. If the dollar remains stubbornly high (because the Fed delays rate hikes, for instance), then the RBA would have room to hack right into the cash rate. If the Aussie dollar starts to fall out of bed (because the iron ore bust goes nuclear or the housing market turns down sharply or both), then the RBA may find itself having to maintain higher rates to protect the value of the dollar.

Kick the Abbott

Aside from the RBA’s ‘surprise’ cut, the other news of note this week was of course the leadership fiasco in the ALP. Or the LNP.

Who knows anymore.

The Very Serious People over at The Australian are worried: Are any of our prospective captains man enough to reverse the nation’s fortunes?

In the accompanying article, Adam Creighton zeros in on the fundamental economic challenge of our time, and misses by a long shot.

The principle of spending restraint enshrined in the Prime Minister’s first budget, whatever its political inelegance, may well be only days away from being scrapped. Tuesday’s Liberal Party ballot may be the tipping point that condemns Australia to gradual economic decay.

The temptation for Mr Abbott’s challengers within the Liberal Party, just as it has been for Bill Shorten in opposition, will be to ditch Mr Abbott’s rhetoric of fiscal prudence in favour of a vapid, trite — but more electorally appealing — “Go for growth” theme.

That will mean, in effect, giving up on spending restraint and endorsing the sort of Keynesian debt and deficits that periodically brings Europe to the brink of financial collapse.

Plainly, the source of Australia’s ‘economic decline’ is not the federal budget deficit. The deficit is small and net public debt is miniscule. The only way that the federal deficit will become a problem as we embark on the long descent from our heady boom, is if the huge private debt burden eventually overwhelms consumers, forcing Australia into recession. We would indeed be in a precarious situation then, given that the federal balance sheet is the critical buttress to the bloated banking system.

Unfortunately, this is not an idle consideration; the federal government is likely to run into spending constraints far sooner than our low debt profile implies, when stresses start to emerge in the housing and eventually banking sectors. But any discussion of the public balance sheet in isolation is disingenuous; it is the private debt burden, combined with the end of a whooping great (and greatly mismanaged) mining boom, that is the true source of our vulnerability.

So then, who among our leading men is up to the task of reversing our nation’s economic decline? I am quite confident that very few politicians have an meaningful appreciation of Australia’s current predicament, certainly Abbott is clueless to the point of farce.

But I am equally confident that Malcolm Turnbull is one of the few.

Abe set for landslide win

Leave a reply

I’ve recently started in a new job, so the pace of posting here at Strayanomics has slowed markedly from its pre-employment levels. My intention is to keep up with the monthly interest rate posts, the value of which I hope is now beyond doubt, along with sporadic commentary accompanying noteworthy events, when time permits.

Japan’s election this weekend is likely to be one such noteworthy event. I highlighted the potential ramifications of this election in my November interest rate update:

As I have argued in the past, Japan’s currency devaluation raises risks of a large-scale shift back to nuclear power, since the economics of importing energy is very poor when they have so much capital invested in a cheaper alternative. Prime Minister Shinzo Abe favours restarting the reactors, but public opinion remains largely hostile to this, given the Fukushima disaster. Japan’s snap election on December 14 could therefore turn out to be of considerable importance to the fortunes of Australian LNG; a strong mandate for Abe would likely see him press ahead with reactor restarts, adding more pressure to LNG spot prices.

A strong mandate appears to be what Abe will receive from this election. From Bloomberg:

Prime Minister Shinzo Abe’s ruling coalition won Japan’s general election, according to an NHK exit poll, which also indicated the bloc may maintain its two-thirds majority in the lower house.

The coalition of Abe’s Liberal Democratic Party and junior partner Komeito will win between 306 and 341 seats in the 475-seat chamber, public broadcaster NHK projected after voting ended at 8 p.m. That compares with the 325 seats the coalition held before the election. Turnout was set to fall to a record low on a combination of voter apathy and heavy snow in parts of the country.

Indeed, very low voter turnout is a big issue for the LDP. Nevertheless, this win has prevented a roadblock being thrown in the path of Abe’s plan to restart nuclear reactors next year, so it seems certain now we’ll see just this.

Japan is of course a key buyer of LNG, so a large-scale resumption of idled nuclear reactors means more stress for Australia’s burgeoning yet already beleaguered LNG industry.

The disease spreads

Leave a reply

Back in August, when I began recording my thoughts on Australian interest rates in detail, institutional economic research teams were in unanimous agreement that we wouldn’t see the RBA cut interest rates any lower. In my impudence, I dissented.

Here were some of the forecasts for the first hike at the time:

AMP – Q1 2015
Barclays – Q1 2015
CBA – Q1 2015
Moody’s – Late Q1 2015
St George – Q1 2015
StanChart – Q1 2015
TD Securities – Q1 2015
HSBC – H1 2015
Nomura – H1 2015
ANZ – Q2 2015
Citigroup – Q2 2015
UBS – Q2 2015
JP Morgan – Q3 2015
Westpac – Q3 2015
RBC Capital – Q4 2015
Goldman Sachs – Q4 2015
NAB – Q4 2015
Bank of America-Merrill Lynch – Q1 2016
Macquarie – Q1 2016
BNP-Paribas – 2016
Deutsche Bank – 2016

It therefore came as a small victory for this humble blogger when two of those shops abandoned their rate hike forecasts this week, and now expect cuts. Perhaps unsurprisingly, the two banks to catch my disease were among the least bullish on the timing of rate hikes.

Deutsche was first out of the gates, revealing they now expect 50bps of cuts next year, with the first in Q2:

Chief economist Adam Boyton believes the strength in the housing market that has been supporting the economy is easing.

“When we combine that with our expectations for the unemployment rate – which is that it will rise all the way through next year – all that suggests to us that there is scope for the RBA to cut rates further,” he told ABC News.

The call runs against most other economist forecasts.

Indeed it does. But perhaps not for long. Following poor national accounts data today, Goldman switched to cuts, with the first coming in March:

Goldman Sachs re-joined the bear pack on Wednesday, forecasting a 25 basis point cut in March and another in August.

“Although third-quarter GDP growth was consistent with our forecast . . . we are shifting our view on interest rates back to interest rate reduction in 2015,” the investment bank said.

“Nevertheless, revisions to the back data and the composition of the GDP data were sufficiently poor to tilt the balance of probabilities towards a rate cut in the first half of 2015 as our base case,” it said.

And NAB is leaving the window open:

National Australia Bank’s senior economist David de Garis said on Wednesday that if leading indicators for the current quarter prove erratic, the central bank might consider more easing.

“The RBA can take some comfort from recent indicators on the economy suggesting that the pace of growth has picked up to some extent,” he said.

“Should such indicators show signs of faltering, then the RBA would need to address whether the current stance of monetary policy is sufficient to aid the economy’s transitioning to higher domestic non-mining growth,” he said.

Late Q1 or early Q2 next year has been my forecast for the first cut (see here, here and here), so it’s a welcome change to have a few professional allies in what was becoming a fairly lonely position.

One by one, they’ll all come around. Though perhaps not Paul Bloxham of HSBC. The poor chap has been predicting rate hikes since 2011, shortly before the RBA started chopping away at the cash rate, taking it from 4.75% all the way down to its current 2.5%.

And it hasn’t stopped yet.

Strayan Rates – November Update

Leave a reply

Let’s start with a quick refresher on where we’re at.

There have been strong countervailing forces exerting themselves on Australia’s economy this year, and this is why the cash rate has gone through an unusual period of stability. The cyclical boost from the last easing cycle has not been sufficient to overcome the structural drag of the softening resource sector, and so the RBA has been unable to seriously countenance higher rates. At the same time, house prices, especially in Sydney and Melbourne, have appreciated excessively, and this has left the RBA reluctant to cut further.

As I’ve hopefully argued with clarity thenceforth, my view at the time of this blog’s establishment was that the structural headwinds battering the Australian economy were too potent for the traditional interest rate-exposed sectors (housing and consumption) to overcome, and so interest rates would fall further before they rose. I have strived to present all possible circumstances that would invalidate this view, but for me none of the arguments against further cuts has been satisfactory.

Developments over the past month have mostly favoured a dovish view on rates. The most important has been the rout in iron ore prices, which has challenged widely-held expectations, my own included, that the final quarter of this year would deliver respite for iron ore producers. Economic policy in China is shifting to a more stimulatory footing, which many hope will presage an improvement in the fortunes of bulk commodities. However, there seems scant chance of the resumption in credit growth and investment being substantial enough to achieve this. Domestic capital expenditure held up better than expected in the third quarter, though was still down 8% from a year earlier.

On the cyclical side, the housing prices were flat in November, with building approvals down sharply and credit growth accelerating slightly. Retail sales were healthy enough, though households appear disinclined to eat into savings. There hasn’t been a material slowing of activity on the cyclical side to warrant cuts just yet, but neither is there much sign of sufficient pressure to raise them.

Terms of Trade

The news this month for Australia’s key commodities has been dour. Iron ore has suffered grievously, a few months ahead of my expectations. There’s increasing agitation globally for reduced dependence on coal, and LNG is facing its own ‘iron ore moment’ due to lacklustre demand and crashing oil prices.

15tl-rbaicp-2

15bl-blkcomp

Coal’s days of boosting Australia’s export earnings are well and truly over. Last month I wrote:

Despite tougher times, coal isn’t going anywhere. Aggressive expansion plans are being tempered, but the industry will continue to make a significant contribution to Australia’s economic output and export earnings. Nevertheless, the days of coal serving up windfall profits and tax revenues are past.

This was a bit lazy, I will admit. Coal is Australia’s second largest export and so in that sense it will ‘continue to make a significant contribution’ to its export earnings. But what we’re concerned with here are rates of change. Will coal support additional gains in Australian living standards in the future? Very likely it will not.

China’s demand for coal has underpinned the windfall in that sector over the last decade. Now that it’s facing severe environmental degradation and hazardous air quality, the government has announced a planned cap on coal consumption. Australia will need to look elsewhere if it wants to expand its export markets, and the only viable candidate really is India. India possess plenty of coal, but its inept state mining company has historically under-delivered. It is intent on changing this, with Power and Coal Minster Piyush Goyal recently declaring, “Possibly in the next two or three years we should be able to stop imports of thermal coal.” Whether this is achieved remains to be seen, scepticism is reasonable, but with China moving against it and oil and gas plentiful, it’s hard to get excited about the prospects for coal.

Whitehaven’s shareholders agree.

In any case, whether or not coal will enjoy an unlikely renaissance in a warming world isn’t of much relevance to my purposes here; there’s effectively zero chance of a short-term rebound in coal that will alter Australia’s interest rate outlook. As such, I won’t bother discussing coal in subsequent interest rate updates unless there’s some news of note.

LNG is starting to get interesting. I haven’t got much in the way of LNG data unfortunately but this chart from David Llewellyn-Smith at Macrobusiness paints the picture.

LNG is mostly sold on long-term contracts linked to the price of crude oil. The above chart shows the Japan Korea Marker, a benchmark constructed by Platts and a proxy for the emerging spot market:

The Japan Korea Marker (JKM™) is the Platts LNG (Liquefied Natural Gas) benchmark price assessment for spot physical cargoes delivered ex-ship into Japan and South Korea. As these two countries take the largest share of LNG imports in the world, the JKM™ is thus a key reference in marking product value/market price from supply source to the destination market.

In the LNG market space, traditional patterns of trade are evolving fast; where cargoes once changed hands only through opaque bilateral deals, the market now exhibits open sell and buy tenders for multiple and single cargoes, brokered trades, cargoes sold in longer chains and speculative trading positions taken up by non-traditional players, adding to liquidity on the spot market.

The recent collapse in spot prices is all the more concerning coming as it has in the lead up to the northern winter. As you can see on the chart above, we’ve seen prices rise in previous years ahead of stronger winter demand.

Weak domestic demand has seen Kogas, South Korea’s monopoly gas supplier, pare back on purchases recently. From Platts:

Kogas, which has a monopoly on domestic natural gas sales, sold 27.6 million mt of LNG over January-October, down 9.6% year on year.

The state utility attributed the decline in domestic LNG sales to the restart of some nuclear power plants, higher coal demand for power due to its relatively lower prices than LNG and weaker power demand due to unseasonably mild temperatures.

And the following is of particular importance:

Kogas plans to work with other Asian LNG buyers to phase out the “Asian premium” that has plagued the region in the past due to the lack of bargaining power and rigid pricing practices, he said.

LNG importers in South Korea, Japan and Taiwan have traditionally paid more for LNG cargoes due to oil-linked contracts and a lack of alternative energy sources.

“Kogas will push for joint purchase of LNG with Asian importers as part of efforts to ease the Asian premium,” the executive said. “Importers in South Korea and Japan would have the same voices.”

Asian demand is reasonably well satisfied at present, yet LNG deliveries to East Asia are set to explode over the next 5 years. Here is the volume expansion from Australia alone (taken from The Future of Australian LNG Exports):

Add in significant expansions to North American LNG capacity, which will arrive a little later than Australian LNG, along with Russian pipelines to East Asia, and you have an emerging gas glut in the Asia-Pacific region. (Though admittedly many of the mooted North American projects will be looking doubtful after the oil price crash.) Thus it’s fair to say an ‘iron ore moment’ is looming over LNG from next year onwards.

As I have argued in the past, Japan’s currency devaluation raises risks of a large-scale shift back to nuclear power, since the economics of importing energy is very poor when they have so much capital invested in a cheaper alternative. Prime Minister Shinzo Abe favours restarting the reactors, but public opinion remains largely hostile to this, given the Fukushima disaster. Japan’s snap election on December 14 could therefore turn out to be of considerable importance to the fortunes of Australian LNG; a strong mandate for Abe would likely see him press ahead with reactor restarts, adding more pressure to LNG spot prices.

Of course, Australian LNG is mostly sold on long-term contracts linked to the oil price, so concerns around an emerging LNG surplus are academic right now, what with the collapse in oil.

The latest hit came last night after OPEC conceded it has no plans to cut production in the face of lower prices. This represents a momentous shift in the dynamics of the oil market, with volatility appearing to be the new normal. In the short-term, many analysts believe $60 is in play, meaning utter carnage for Australia’s gold-plated LNG projects, which are all among the most expensive in the world.

In any case, LNG is not going to provide much of a boost to the economy once it starts leaving our shores in record volumes, even if the oil price does rebound next year. Employment will be much lower in the operational stage than during the construction phase, and the squeeze on east coast gas supplies will hurt local industry. The only real positive effect will come via higher tax receipts, and obviously these are looking fairly lean now.

Iron ore has been bludgeoned over the last month, notwithstanding more positive price action over the past couple of sessions.

Here was my assessment of things in the October update:

Recently I noted that the worst may well have passed for the iron ore miners in 2014. Spot found legs for a solid bounce after that, however as you can see it didn’t manage to hold its gains. Still, buying returned at the end of last week around the $80 level, and it looks unlikely we’ll see falls much below this for the remainder of the year, owing to much improved profitability amongst Chinese steel mills, a thawing of credit conditions in China and some degree of seasonal inventory restock into the year’s end. However, without a fundamental shift in Chinese policy settings, the bounce will be short and soft relative to past years. And with no sign of a let up in the pace of supply expansions from the majors, further declines in iron ore next year are virtually baked in.

$80/t has since crumbled and we’re presently sitting at $70/t (Qingdao port price). The ‘further declines’ I expected to arrive early next year came ahead of time, the reason being an absence of seasonal restocking activity, which I discussed here. The market got briefly excited about an interest rate cut from China’s central bank last week, but that’s faded quickly. The last couple of sessions in China have seen strong buying both steel and iron ore, which could extend a bit further, but the fundamentals for both remain so poor that it’s hard to see a pronounced rebound into the year’s end.

Iron ore is the main drag on the Australian economy today. Over the next year declining mining investment will probably assume that primacy, but what Australia is going through right now is quite simply a monstrous terms of trade bust, one of the biggest and baddest in our history. Without large reductions in supply, it’s likely we’ll see spot iron ore near $50/t by the end of next year. Thus, unless we get a full-blown resumption of the Chinese credit and property booms, and soon, the situation with iron ore makes it very hard to see the RBA hiking rates with the next move.

The iron ore slump (-47% this year), has mostly been about the huge expansion in supply and the endurance of existing high-cost production, especially in China (the failure of Chinese steel demand to continue rising inexorably is the other important aspect). Much of this new supply has come out of Australia, hence our trade balance has not deteriorated too severely thus far.

There will likely be further pressure on the trade balance over the next year, although I don’t expect the headline figure to be all that bad, owing to even more iron ore out of the Pilbara and the ramp up in LNG exports. This will be of little comfort, mind you, since higher volumes are of secondary importance when set against corporate profits, which are taking a beating in both sectors.

Here’s the most recent terms of trade chart (Q3 national accounts arrive next week). Once recent falls in spot prices flow through to contracts, the terms of trade will be approaching the nadir of 2009.

It will be a brave or desperate RBA that hikes interest rates in the midst of a terms of trade bust such as the one we are in the grip of.

China

The Chinese economy continued to slow in October, emphasising why the government has lately shifted policy towards a more stimulatory footing.

Industrial production, fixed asset investment and retail sales growth rates all registered falls from the previous month (charts from China’s National Bureau of Statistics).

Screen Shot 2014-11-26 at 5.34.32 pm

As I outlined in a post on China a few months back, investment levels grew to account for an unsustainably high proportion of GDP following the financial crisis in 2008. Why are very high levels of investment a problem? Investment is intended to raise output of goods or services in the future. If too small a proportion of an economy consists of consumption, then it risks insufficient demand for the extra goods and services produced by all that investment, and therefore poor returns for investors. When high levels of investment have been been funded by a massive expansion in credit, this can be calamitous.

For this reason, the Chinese government has signalled its intention to rebalance its economy away from investment in ‘fixed assets’ (factories, infrastructure and apartment blocks) and towards domestic consumption. It is welcome then that retail sales have declined by less than fixed asset investment over the past year, and that the services sector has expanded more rapidly than manufacturing, but there is still a way to go. The challenge is immense; according to government researchers, $6.8 trillion of wasted investment has been undertaken since 2009. All this spending has of course contributed enormously to Chinese GDP growth, and I simply cannot see how growth rates aren’t going to slow markedly over the coming years as this uneconomical investment binge works its way through the system.

Indeed, without a continuous acceleration of credit, Chinese property prices are sinking. Property data released last week acted as the catalyst for the capitulation in iron ore. At the national level, year-on-year prices are falling at their fastest pace in at least a decade. (Chart from Tom Orlik):

In response to soft data and the bleeding in the property sector, which is itself an automatic consequence of the restraints placed on credit growth, the People’s Bank of China (PBoC) cut interest rates on Friday, adding to the easing of mortgage lending rules in September.

Although this move won’t turn the economy singlehandedly, if it is accompanied by a broader easing of credit conditions then some argue it could herald a lasting rebound in property and support demand for bulk commodities.

I remain highly sceptical that Chinese policymakers are seeking to reboot the credit boom. Debt-to-GDP has soared to 250% this year, from 147% in 2008. Although other nations have higher debt levels, such a rapid build-up of debt is a big concern, especially considering that China isn’t nearly as wealthy as other nations with comparable debt ratios. Moreover, much of the investment spending this credit has funded is are not going to provide a sufficient return, and so the quality of the debt is rather poor. China’s policymakers seem to understand this. I believe they’ll be looking to limit the stress on borrowers as much as possible, without reigniting credit growth. In particular, the shadow (nonbank) finance sector looks to be well and truly curtailed. This, at any rate, is how I am reading the interest rate cut: the government wishes to establish a floor under growth, as far as its feasible, rather than blow the roof off again.

When we remember that inflation has been trending down over the past 12 months, especially in the second half of this year, its clear that the recent interest rate cut is as much about reversing passive monetary tightening as it is active monetary loosening.

With inflation low and falling, a cut was the correct decision. I am doubtful this move presages a return to the credit boom days, and in any case it would need to be truly enormous now to mop up the sheer scale of excessive capacity in iron ore. Chinese policymakers may yet ride to the rescue, but in spite of recent supportive measures, we have not seen policy shifts substantial enough to alter the bleak outlook for bulk commodities.

Investment

I covered yesterday’s capital expenditure data in detail here.

Capex has dodged steeper declines through resilient spending in WA and the Sydney property boom. Without further interest rate cuts, Sydney’s boom will start to cool within 6 months or so. And investment in WA is all about iron ore supply expansions, which hurt the terms of trade, and are likely to slow sharply next year as a result of the iron ore price crash (Fortescue’s announcement today is just the beginning). So although last quarter’s result was a positive, the future remains grim for capital spending.

Public Finances

I have mentioned a number of times how damaging the iron ore rout would be to the West Australian government’s budgetary position, and here’s why:

Spot iron ore is sitting at $70 at the moment, over 40% below what the WA government forecast. Next year it could well average around $60, half of what’s been forecast. In the government’s own words, “General government revenue is also highly sensitive to the iron ore price, with iron ore royalties projected to account for 19.7% ($5.6 billion) of total revenue in 2014-15.” It estimates $49m in lost revenue for every dollar fall in spot iron ore.

The lower Australian dollar will provide some minor respite for the budget, but not nearly enough. Stay tuned for the Great Western Austerity Drive next year.

Although iron ore forecasts in the federal budget have not been anywhere near as aggressive as WA’s, the drop in prices has likely added around $10bn to the deficit this financial year, taking it to $40bn. Should the pain continue next year, it will obviously hit the budget even harder. The pressure will remain on the Treasurer to find savings that can pass the Senate, and these will no doubt be similarly popular to the ones announced in May. The ongoing fiscal retrenchment will likely dampen consumer sentiment in the coming months, making a consumer-led rebound a tougher ask.

Housing

The housing sector moderated somewhat over the month, with Sydney and Melbourne diverging.

ABS data for building activity is only released quarterly, however the most recent monthly building approvals data registered a sharp drop of 11% from the previous month in seasonally adjusted terms.

As you can see, the overall fall was largely due to the fall in approvals for units (apartments), which declined 21.9% between August and September. Since Melbourne is determined to become ‘Manhattan Down Under’, much of the apartment building surge has been concentrated in Victoria. Unsurprisingly then, September’s fall in national approvals was driven by Victoria.

These data are fairly volatile, so one month doesn’t tell us a great deal. We’ll get the October data next week, and it will be interesting to see if approvals rebound. However, with rents growing far slower than house prices, increases in housing supply will steadily inflate valuations.

HousePricesAnnualChange

Following the steep decline in interest rates between November 2011 and August 2013, the economic case for investing in houses improved substantially. But the consequences of this, namely house price growth far outstripping rental growth as investors piled in and supply increased, have eroded the attractiveness of property as an investment. Of course, Australian housing investors are not in it for the yield, they are in it for capital gains. Nevertheless, after-tax cash flow is important for justifying the borrowing required to speculate on houses, so tumbling yields will, in time, crimp investment demand. Valuations could go truly idiotic in the meantime, but eventually more cuts are going to be required to keep the party rolling. As I’ve mentioned, I can see it running for another 6 months or so, absent some external shock, before cooling on its own accord. If the structural downturn bites harder, property could easily roll over sooner.

The RBA released credit data for October today, which showed an uptick in credit growth over the month.

In comparison to the last speculative housing boom, overall credit growth has been subdued. It is important to recognize though that we’re beginning from a much higher base level of debt this time around. The jump in investor loans is therefore a concern, despite the growth rate being low historically. Also, with national income set to decline, expansions in risky borrowing are undesirable and potentially destabilising; cutting rates could fuel this fire.

This leads some observers, such as those in the OECD, to argue that current activity in the property market is enough to warrant higher interest rates. Higher rates would certainly hit this sector, but they would also hit the economy very hard, right as it’s entering a pronounced structural slowdown. This would be madness, in my view, and its why I cannot see rates rising. There are other tools to slow housing, and the RBA and APRA are presently canvassing their options. At most, if property burns brighter into the new year, it will defer interest rate cuts. In time, the structural weaknesses of the economy will see property roll over. When it does, cuts to interest rates will follow quickly, if they have not already arrived.

Consumers

The Australian consumer is exhibiting less inclination to spend aggressively out of current income than during previous property booms.

There’s been some divergence in consumer sentiment reports this year, with the ANZ-Roy Morgan survey showing a mild improvement, but the Westpac-Melbourne Institute survey showing a weakening. From ANZ chief economist Warren Hogan:

Job vacancies data last week showed labour demand in the non-mining sector continues to gradually improve, particularly in labour-intensive industries such as construction, health and retail. Alongside low interest rates and rising house prices, this should support consumer confidence and retail spending as we head into the Christmas season.

And from Westpac chief economist Bill Evans:

In the near term, prospects for a boost in consumer spending going into the end of the year are not encouraging.

So, ‘who really knows what consumers are thinking right now?’ , seems to be the conclusion. The large decline in oil prices could help sentiment if it ever feeds through to petrol prices. But the salient point, I think, is that as the terms of trade bust and investment downturn gather pace, and as public balance sheets deteriorate, it’s going to be increasingly hard for the consumer to remain so upbeat and willing to spend that he/she overrides this structural downturn.

In any case, with national income falling, consumers will need to dig deeply into savings to deliver the jump in spending required to lift interest rates. As long as the savings ratio remains elevated, consumption will not rise strongly enough to overwhelm weakness elsewhere.

Employment

The Australian Bureau of Statistics’ labour force survey has suffered well-publicised issues in recent months, so the official data is not as reliable as it ought to be, but the trend in unemployment remains up.

And here’s the breakdown of the states and territories:

Public sector layoffs in the ACT and Queensland, along with the beginning of the LNG investment wind-down in the latter, are hurting employment in those states, and will continue to do so. Strong population growth is driving the Victorian economy at present, instead of the other way around. While this works at the aggregate level, with overall state demand rising, it’s meant that unemployment has trended higher. Also troubling is the stubborn rate of unemployment in NSW, in spite of its property bonanza over the past couple of years. With the most spritely phase of the boom likely past, it’s difficult to see where a sustained improvement in employment will come from.

Warren Hogan obviously disagrees, and cites the ANZ job ads report as evidence:

The modest improvement in ANZ job ads in October is an encouraging sign that the pick-up in labour demand is continuing. In our view, this should feed into better employment growth outcomes and see the unemployment rate stabilise.

Screen Shot 2014-11-26 at 9.46.53 pm

As you can see on the second chart, there’s been a clear divergence in the past 18 months between job ads and the unemployment rate. This is historically unusual, and indicates either that the labour market is ready to turn, as ANZ’s economists believe, or that the economy is in the grip of a highly anomalous structural adjustment that will see existing jobs shed faster than new ones become advertised. Most of the uptick in job ads will be connected to the frothy segments of the NSW and Victorian property markets. As I’ve made abundantly clear, I am sceptical that this froth will last for much longer.

Inflation

As discussed in the previous interest rates update, there’s little in the way of inflationary pressures for the RBA to worry about. Although the Consumer Price Index had bumped up against the top of the RBA’s band (2-3%), this was almost entirely driven by the depreciation in the Australian dollar last year, and therefore not something the RBA needed to counter with monetary policy.

Nominal wage growth is currently the lowest on record, though the ABS only has a wage price index reaching back to late 1990s. However, Australia experienced far higher inflation in the preceding decades, so current levels are likely to be lowest in a very long time. Real wage growth is also low, flirting with negative rates.

In short, there is nothing in the prices of labour or goods and services to warrant monetary tightening.

Exchange Rate

As I have written previously, a large and sustained drop in Australia’s real exchange rate is critical to achieving genuine economic rebalancing (as opposed to a short-term cyclical sugar-hit). Therefore, a deep fall in the exchange rate could defer or even eliminate the need to for the RBA to cut rates.

And indeed, there’s been a welcome decline in the Australian dollar in the last few weeks.

These moves have been driven in part by a gradual recognition that rates will need to fall in Australia. What this means is that if the RBA does not eventually cut rates, or fails to signal that they will, the Aussie dollar’s drop will be probably limited. I can see it moving to .8000 now without too much trouble, on a technical basis it is looking quite sickly, but I cannot see it falling hard enough to negate the need for rate cuts.

Conclusion

It remains very difficult to see the RBA hiking rates in light of the ongoing structural headwinds. The cyclical boosters are still supporting activity, but by their very nature these growth drivers require continual monetary easing to be maintained in the current environment. Therefore, if rates do rise, the Australian economy will quickly lose its only propellants, and this will necessitate lower rates again in fairly short order. I continue to expect rates to remain on hold for another 3-6 months before the RBA cuts in Q2 next year.

Capex holds up

Leave a reply

The results of the private capital expenditure survey for the September quarter were released by the ABS this morning, showing a seasonally-adjusted .2% rise, in volume terms, on the June quarter. This solidly beat expectations for a 1.9% drop.

In dollar terms, capital spending by the mining sector dropped 3% over the quarter and manufacturing fell 1.3%, with these falls offset by a 5.6% jump in ‘other selected industries’. Total capital spending was down 4.6% ($1894m) on the same quarter last year, mining was -14.2% ($3475m), manufacturing -10.5% ($253m), and ‘other selected industries’ +12.8% ($1833m).

The main driver of capital spending by ‘other selected industries’ over the past year has been the ‘rental, hiring and real estate services’ industry grouping, which has risen by 40% and contributed $838m of the $1833m in additional spending by that sector. Contributions have also been made by businesses in ‘retail trade’, ‘construction’ and ‘financial and insurance services’.

CapexOther1

Those industry groupings cover businesses benefiting from the last monetary easing cycle and the consequent boom in house prices. Unsurprisingly, seeing as it’s the nucleus of the boom, NSW has accounted for over half the increase in capital spending by ‘other selected industries’ over the past year.

Here’s the division of total capital spending by state.

Evidently, the cyclical boost emanating from the Sydney property sector and the resilience of mining investment in WA have cushioned the overall blow to capital spending in the past year. The latter of those points is important. If capex holds up in WA, it’ll come at the expense of the iron ore price, since capital spending in WA is almost entirely constituted by iron ore capacity expansions.

Here are the expectations for capital spending this financial year:

Mining

Other Selected Industries

Manufacturing

Manufacturing is all but dead so we can ignore that until we see the dollar fall 20-30% in real terms.

Without further cuts to interest rates, the cyclical upswing in NSW is likely to run out of puff over the next 6 months or so, in which case I wouldn’t be surprised to see expected spending by ‘other selected industries’ moderate somewhat by the time the full year’s spending has been recorded. Activity in this interest rate-sensitive space reflects the RBA’s strategy for ‘rebalancing’ the Australian economy as the resource sector slows. This is bubbly economics: papering over a structural downturn with a cyclical upturn in borrowing, asset speculation and consumption. The US famously tried this strategy after the tech wreck early last decade, and it ended up with a catastrophic housing bust.

Thankfully, Australians have mostly kept their heads so far, and the bubbliest segments of the economy are confined to Sydney property speculation and manic Melbourne apartment building. Credit is not growing too rapidly and household savings rates remain reasonably healthy (bearing in mind, of course, that households are already heavily indebted). Nevertheless, the bubbly segments have lately caused enough consternation within the RBA and APRA for these institutions to move forward with ‘macroprudential regulations’, specifically aimed at reducing macroeconomic risks in the property sector and banking system. Despite having cheered it on, the RBA finally grew wary of the housing beast.

It remains to be seen how stringent macpru ends up being in Australia, but it is a welcome move. Some commentators will be inclined to regard this upturn in housing-related activity as healthy rebalancing, but in my view a structural downturn needs a structural remedy, not a temporary sugar hit. We need a lower real exchange rate and productivity-enhancing reforms and infrastructure spending to boost investment in non-mining tradable goods industries. Until we get that, it’s hard for me to get excited about any purported ‘rebalancing’.

As to mining investment, there’s little doubt that we’re going to see it deteriorate sharply over the next two years, particularly given the recent carnage in iron ore and crude oil prices (which LNG prices are linked to). The BREE recently published its forecasts for mining projects.

It’s safe to say that ‘possible projects’ are extremely unlikely, and also that many ‘likely projects’ will fail to break ground as well, without big rebounds in oil and iron ore prices, or a sharp fall in the Australian dollar.

Bonus Chart

PBoC finally caves

Leave a reply

Reigning in a credit bubble before it bursts is a mightily taxing task. China’s authorities have been holding firm admirably in the face of China’s cooling economy, but the chilliest property market in a long while has at last provoked a response: tonight the People’s Bank of China cut benchmark interest rates for the first time since July 2012.

Bloomberg has details:

The one-year deposit rate was lowered by 0.25 percentage point to 2.75 percent, while the one-year lending rate was reduced by 0.4 percentage points to 5.6 percent, effective tomorrow, the People’s Bank of China said on its websitetoday.

The reduction puts China on the side of the European Central Bank and Bank of Japan in deploying fresh stimulus and contrasts with the Federal Reserve, which has stopped its quantitative easing program. Until today, the PBOC had focused on selective monetary easing and liquidity injections as China heads for its slowest full-year growth since 1990.

…

Aggregate financing in October was 662.7 billion yuan, the central bank said Nov. 14 in Beijing, down from 1.05 trillion yuan in September and lower than the 887.5 billion yuan median estimate in a Bloomberg survey of analysts. New local-currency loans were 548.3 billion yuan, and M2 money supply grew 12.6 percent from a year earlier.

As that article notes, credit growth in October was weak despite the widely-publicised shift to looser mortgage conditions in September. This change in policy stance provoked an avalanche of new property starts, which will in turn keep the pressure on prices.

This interest rate cut does look entirely appropriate in the context of China’s economy today, and to be honest there was little choice for the PBoC given the extraordinary depreciation in the yen and signs that the ECB could be joining the party before too long. (See this post for more on that.) The economy has continued to weaken in the past few months, and although it’s too early to judge the effects of recent changes to mortgage lending rules, it does seem that more needs to be done to arrest the decline in property prices, especially seeing as the market is now almost certainly structurally oversupplied (a point that was less clear in 2012, when property last turned down).

As I’ve emphasised many times on this blog, one of the trickiest things about forecasting Australia’s short-term outlook is the ever-present Chinese policy enigma. Many commentators are eager to point out that China’s slowdown this year, with its knock-on effects to Australia’s key export commodities, has been purposely engineered by its masterly policymakers. Thus, when things look like slowing down too much, all that needs to be done is a slight easing off on the brakes and a light tap to the accelerator, and all will be well.

The obvious problem with this appraisal is that China’s debt levels have exploded since 2008 under the deft touch of China’s policymakers:

China’s total debt reached 251 percent of gross domestic product as of June, up from 234 percent in 2013 and 160 percent in 2008, according to Standard Chartered Plc estimates.

Fortunately, they seem to have a firm grasp of their failings in this regard, and policy has been crafted this year with a clear objective of credit rationalisation: slow the overall rate of credit growth, hit shadow banking hard, and take the froth out of property prices. The great challenge of course is that China’s economy has grown hugely dependent on this model. As credit growth slows and questionable investment spending is restricted, the economy slows.

Along with the changes to mortgage rules in September, this interest rate cut sends a clear message that China’s authorities have become uncomfortable with the resulting hit to the economy from their credit tightening, and are prepared to tolerate looser conditions.

So, is this enough to fundamentally shift the outlook for the Middle Kingdom, and with it Australia’s?

I’m sceptical that this cut alone will be enough to reignite the credit binge necessary to produce a large upswing in activity, more likely it’s intended to help the economy glide towards slower growth rather than crash. And I wouldn’t be jumping to the conclusion that the government has abandoned its commitment to credit rationalisation. My view is that authorities are looking to place a floor under growth, rather than blow the roof off again.

I know I’ve said it a few times in the last couple of months, only to see the market cruelly mock my optimism, but I’ll try again anyway: I won’t be surprised if this move from the PBoC offer respite to our beleaguered iron ore miners by seeing off a new low in spot this year. By don’t expect a stomping rebound, since nothing has fundamentally changed in the market, and do expect a resumption of pain next year.

AUD has been heavily bid since the announcement, up about a cent against the USD, as have equities.

Straya at the Moment – Part 2

Leave a reply

Part 1 – The Making of the Australian Triumph

I’m sure George Megalogenis, journalist and author The Australian Moment, was being sincere when he wrote:

Are we in danger of becoming a great country? When I put the question to politicians and officials in interviews for this book, the majority response is to laugh or sigh.

Be that as it may, just because Australian politicians and officials weren’t seized by a collective great power delusion doesn’t mean that Australian Exceptionalism was absent from our policymaking mindset; far from it. This sense of exceptionalism manifested itself in a constant tendency to overestimate the durability of the mining boom, which has lasted all the way through to the present day. While the Bureau of Resources and Energy Economics has traditionally been the main offender, the most risible delusion today belongs to the Western Australia government, which has forecast iron ore at $122 for 2014-15. So far iron ore has averaged $86 this financial year, and is currently sitting at $70/tonne. There’s been cascade of revisions to iron ore price forecasts lately, and Chinese futures are pricing spot at close to $60 by May next year. Plainly, the WA budget is in big trouble. Although federal budget forecasts have been less sanguine, Canberra is still facing an unpleasant shock; as I’ve argued since this blog’s inception, the public balance sheet is under far greater stress than is typically recognised, mainly because iron ore is in significantly more trouble than has typically been acknowledged (until very recently, of course, when the market made it impossible to deny).

The idea that our prosperity would be underwritten by demand for our minerals and energy has had a pervasive effect on politics over the past decade, and led to what Professor Ross Garnaut dubbed the ‘Great Complacency’. This argument is a noticeable departure from the one advanced by Megalogenis, which I covered in the previous post. This is actually quite odd, seeing as he agrees with most of the particulars but arrives at a completely different conclusion. The thrust of the ‘Great Complacency’ argument is that there weren’t sufficient adjustments made to fiscal policy to reflect the transient nature of the terms of trade boom. We can see this plainly enough in the rather pathetic fact that we’ve reached the denouement of a huge mining boom with a federal budget mired in structural deficit and a current account deficit that never even threatened to close (the current account balance is the trade balance plus net foreign income).

Worse than that, the initial phase of the terms of trade boom, prior to the financial crisis, saw some of the largest current account deficits of modern times, as Australian households threw aside the old art of saving in the new millennium.

This was the legacy of the housing frenzy, which peaked in 2003-04. It was also the period through which fiscal settings should have been much tighter, as corporate tax revenues started pouring in from the early stages of the boom. Alas, the Howard/Costello budgets were too generous, delivering tax cuts and expansions to various entitlement programs, which boosted overall spending in the economy.

The combination of spendthrift households (at least until 2006, when the saving ratio began to rise), and a government eager to feed the habit, left the RBA with the job of leaning against the boom.

This monetary tightening formed part a deliberate strategy for adjusting Australia’s economic settings in response to the terms of trade boom. There were basically three ways that Australian policymakers could have dealt with the boom: a) real exchange rate appreciation by domestic inflation, b) real exchange rate appreciation by currency appreciation, c) a forcible increase in national savings. (Or some combination of all three, of course.) Understanding which approach was adopted, why it was adopted, and what it entailed, helps us understand Australia’s current outlook.

Super-cycles

The boom Australia has just lived through is commonly referred as a commodity price super-cycle. Before I look at the a various ways of responding to the boom, this paper (fee required) by David S. Jacks has an excellent description of what we’re talking about when we refer to commodity price super-cycles (highlights my own):

In this paper as in others it follows, commodity price super-cycles are thought of as broad-based, medium-run cycles corresponding to upswings in commodity prices of roughly 10 to 35 years. These are demand-driven episodes closely linked to historical episodes of mass industrialization and urbanization which interact with acute capacity constraints in many product categories—in particular, energy, metals, and minerals—in order to generate above-trend real commodity prices for years, if not decades on end. Significantly, this paper finds that fully 15 of our 30 commodities are in the midst of super-cycles, evidencing above-trend real prices starting from 1994 to 1999. The common origin of these commodity price super-cycles in the late 1990s underlines an important theme of this paper: namely that much of the recent appreciation of real commodity prices simply represents a recovery from their multi-year—and in some instances, multi-decade—nadir around the year 2000. At the same time, the accumulated historical evidence on super-cycles suggests that the current super-cycles are likely at their peak and, thus, nearing the beginning of the end of above-trend real commodity prices in the affected categories.

Exactly what Australia has just gone through, in other words.

Plans A, B and C

Primary resources account for the vast majority of Australia’s goods exports.

As a result, Australia has always been prone to commodity price boom and bust cycles.

Terms of trade booms entail a significant rise in Australia’s national income, since we’re able to exchange the goods we export for more (or higher value) imports. We get richer.

But most of us don’t sell iron ore on the world market, so how does the soaring iron ore price impact those of us who aren’t directly remunerated by the iron ore industry?

There are a few channels through which this can occur, but essentially it’s through an appreciation in the real exchange rate. The exchange rate that gets quoted to you when you travel overseas is the nominal exchange rate, which doesn’t necessarily tell us much about the relative purchasing power across different countries (think of nominal as ‘in name only’).

This point can be illustrated by way of a simple, stylised example: Suppose Australia’s nominal exchange rate is fixed against the US dollar at parity, but Australia has very high inflation, say 100% annually, whereas US inflation is zero. In a year’s time, you’ll (hopefully!) be getting twice as many Australian dollars in your pay check each week. The prices of haircuts and beers and electricity in Australia have also all doubled, so in real terms you’re no better off buying things in Australia. But you can still exchange each Aussie dollar (of which you now have twice as many) for one US dollar, since the rate is fixed at one-for-one. And since inflation is zero in the US, the prices of haircuts and beers and electricity haven’t changed at all. So if you exchange your Aussie dollars for US dollars, you can head over to the US and buy twice as much stuff! Despite there being no change the nominal exchange rate, Australia’s real exchange rate has appreciated.

An appreciation in the real exchange rate has accompanied all of Australia’s terms of trade booms.

Here’s a close-up of the most recent boom:

Screen Shot 2014-11-12 at 9.28.37 pm

When the terms of trade enters an upswing, additional income starts flowing into the economy, raising profits and salaries in affected industries and boosting government revenues. Unless the government purposely restricts spending by tightening the budget, this increase in income flows into the rest of the economy. Firms raise investment and households consume more. Until 1983, when Keating floated the dollar, Australia’s nominal exchange rate was fixed (well, tightly managed). If the nominal exchange rate is fixed, then there’s no automatic mechanism to make life harder for trade-exposed industries that are not directly benefiting from the terms for trade upswing, so firms aggressively compete for scarce labour, driving wages higher. As spending and income rises throughout the economy, inflation rises. Thus, as I described above, Australia’s real exchange rate rises.

Although I’m not sure it was really anyone’s plan in the past, for convenience I’ll call this Plan A for responding to a terms of trade boom: permit domestic inflation to rise. The biggest problem with this is that it’s all well and good during an upswing, but it can be most damaging during the downturn, and typically entails a recession. The reason being that the economy has become uncompetitive at the new level of the real exchange rate. Returning to the Australia-US example above, if Australians can afford to buy more US-made beer than Australian-made beer, and they can since inflation is so high in Australia relative to the US, then they’ll shift their demand to US-beer. This behaviour is repeated for most other tradable goods, and so higher inflation hurts Australian businesses. When the positive effect of the terms of trade upswing abates, the now-uncompetitive economy cannot sustain full employment, and slips into recession. (Generally there was some belated monetary tightening to address rising inflation, and this would exacerbate the downturn when it arrived.)

This is why it’s commonly agreed that one of the central achievements of the most recent terms of trade boom has been the prevention of an inflationary breakout (see CPI chart above for comparison to past booms). Instead, since it was accepted that the real exchange rate had to rise, the nominal exchange rate did the heavy-lifting, allowing inflation to remain in check (or ‘anchored’, in econospeak). That is, instead of the Australian dollar being fixed against other currencies, it traded freely, and rallied very strongly indeed.

In Macroeconomic Consequences of Terms of Trade Episodes, Past and Present (2014), Atkin et al had the following to say (p. 21):

Prior to the current terms of trade cycle, the RBA adopted an inflation-targeting framework, with the goal of keeping consumer inflation between 2 and 3 per cent on average over the medium term. This framework has provided a clear nominal anchor which, together with changes to the structure of the labour market described in Section 4.5, limited the feedback of the boom to economy-wide prices and wages. Notwithstanding the very significant rise in the terms of trade in the current episode, inflation has been well contained, especially when compared to the experience of the 1950s or 1970s. The floating exchange rate and inflation- targeting framework has also provided the RBA with the flexibility to maintain an accommodative stance of monetary policy more recently to support domestic demand since the terms of trade has started to fall.

And in an earlier RBA research paper, titled, The Mining Industry: From Bust to Boom (2011), Connolly and Orsmond had a similar take (p. 47):

Australia’s freely floating exchange rate has allowed a real appreciation to occur in response to the 2000s mining boom without the adjustment coming through high inflation, as occurred under the less flexible exchange rate regimes of the 1970s and early 1980s. The surge in mining export receipts in the late 1960s and early 1970s generated strong domestic demand and placed upward pressure on the exchange rate. The Government kept the exchange rate fixed, building foreign reserves and allowing the domestic money supply to grow at an annual rate of over 20 per cent in the early 1970s (Figure 25). When the Government finally revalued the exchange rate in late 1972 and 1973, it was too late to restrain inflation, which had drifted up from around 3 per cent in the late 1960s to 7 per cent in 1971. In contrast, during the 2000s, the floating exchange rate began appreciating as the global economy recovered from the 2001 recession, and appreciated further over the remainder of the decade as the terms of trade continued to rise. Furthermore, when commodity prices moved sharply in 2008/09, the exchange rate adjusted to cushion the shock to the economy. Overall, the higher exchange rate has helped to offset the expansionary effect of the increase in mining export receipts and investment.

I’ll call this Plan B: still allow the real exchange rate to rise in response to the terms of trade upswing, but keep inflation anchored, prevent a wage breakout, and leave it to the nominal exchange rate to rise and fall in accordance with the economy’s needs. This entails is a shrinking of various other tradable-goods sectors in the economy, which can’t compete internationally when the Aussie dollar is so strong, to ‘make room’ for the booming resource sectors. As the nominal exchange rate rises, Australians get richer in real terms and demand more imported goods, which are cheaper relative to locally-produced goods. Consequently, trade-exposed sectors and businesses which aren’t benefiting from the boom start to struggle; they reduce their demand off workers and curtail new investment. This process reduces inflationary pressures in the economy during the upswing.

Screen Shot 2014-08-26 at 11.50.34 am

What makes a nominal exchange rate appreciation so attractive is the comparative ease with which the economy will adjust to the downswing in the terms of trade, at least in theory. As the terms of trade decline, and drag down national income with it, the Australian dollar will lose value. As the Australian dollar loses value, sectors which were getting squeezed by the booming resource sector will see an improvement in demand for their products, and this will support business investment and employment.

So we’ve arrived at one of the fundamental points of the Australian economy today: With the terms of trade bust and the resource investment wind-down gathering pace, the Australian dollar must fall substantially from its current level. Most people I think probably appreciate this intuitively. However, we are talking about a very big adjustment indeed, 20-30% lower than where the Aussie dollar is trading presently, at least.

If this nominal exchange rate depreciation is not realized, if the Australian dollar does not lose value against the relevant currencies of trade partners and competitors over the next couple of years, unemployment will rise significantly. Of course, one way or another, it almost certainly will happen. It’s a matter of timing. The Aussie dollar will fall when it becomes clear than Australian interest rates are going a lot lower and most likely staying there for an extended period. Therefore, the longer the RBA waits, the worse the employment situation will get. But rising unemployment is itself one of the most important indicators watched by the RBA, so in that sense the bank will be forced to act sooner or later. Whether the board is proactive or reactive in this instance is the main question.

Sounds pretty simple, doesn’t it? All the Australian dollar needs to do is fall precipitously and the economy will be fine! Would that it were that easy.

Sadly the Australian case is complicated by the situation in the housing market. Although the economy needs lower rates to bash the currency (there are other options but the RBA is loath to countenance these), this action invariably provokes a rapid and destabilising response in the housing market. In the next post I’ll run through the challenge associated with the housing market, and why it complicates the real exchange rate adjustment.

Must we grow richer?

So far we’ve seen Plans A and B for responding to the terms of trade boom. Each entailed a significant real exchange rate appreciation, by domestic inflation and nominal exchange rate appreciation, respectively. But did the real exchange rate have to rise so strongly in response to the upswing in the terms of trade?

The current account balance is the difference between domestic demand for goods and services and domestic supply (you need to add in net foreign income earned in the period as well). As such, a country running a current account deficit is purchasing more goods and services than it is producing. To do so, it must borrow the difference from international lenders (or sell assets to international investors). A country that is borrowing more from than it is lending internationally, is running a capital account surplus. Together, the current and capital accounts make up the balance of payments.

One might be excused for assuming that Australia would have run significant current account surpluses during the biggest boom in exports in over a century. But in fact, as my chart above illustrates, at no stage during the boom did Australia notch up a surplus. Indeed, before the financial crisis in 2008, Australia’s current account deficit reached record highs.

This occurred by a combination of the rising real exchange rate and rising foreign borrowing. As the exchange rate rose, the cost of imports fell and households purchased more of them. There was also a significant increase in household leverage which began in the mid-1990s and continued through to 2008. After 2008, when households boosted savings out of current income (which lowered demand for imports), the trade balance sporadically swung into surplus, but owing to Australia’s substantial foreign liabilities, our net income on foreign investments is deeply negative, so the current account remained in deficit.

This failure to record current account surpluses and reduce Australia’s net foreign liabilities during the boom years leads some to complain that Australia squandered the boom. I count myself among this group. Current account deficits certainly aren’t intrinsically bad; if there’s an abundance of productive investment opportunities in your country but insufficient domestic capital or technological knowhow to exploit them, then importing foreign capital is sensible. But what net foreign liabilities mean is that part of the income generated in your economy each year must flow overseas in the form of interest and dividends. Therefore, large accumulated deficits are a drain on national income. They also leave the economy exposed to the availability of foreign capital, which can pose risks to the banking system.

I am of the view that the Australian government would have been better off running very big budget surpluses before the financial crisis, and parking these savings in an offshore sovereign wealth fund (whether this would’ve been politically feasible is another matter entirely). This would have been achieved by withholding almost all of the increase in additional revenues flowing from booming corporate tax receipts, which should have been further inflated by a pre-existing rent tax on resources. One consequence of this policy would have been lower household spending, including on imports, since tax cuts and middle-class entitlement spending fuelled consumption. With lower imports and booming exports, the current account deficit would have declined. In addition, lower household spending would have lessened the need for the RBA to raise interest rates as high as it did, which would have limited the appreciation in the real exchange rate. Again, this would have lowered spending on imports and eased the hit to non-mining trade-exposed sectors.

Had this policy been in place when the financial crisis arrived in 2008, the federal budget would have been in such healthy shape that subsequent deficits would have been far lower, and in fact the budget could have conceivably remained is surplus. This would have afforded the government far more breathing room to set stimulatory fiscal policy today.

This then is, or was, Plan C: Instead of allowing the real exchange rate to appreciate so strongly, irrespective of how it happens, lean heavily against the boom by running very big federal budget surpluses and reducing Australia’s net foreign liabilities. Some manifestation of Plan C was basically the alternative to Garnaut’s ‘Great Complacency’. In adopting this approach, comparatively subdued household spending acts as a release valve, mitigating the risk of the economy overheating. Contrast this with Plan B (real-by-nominal exchange rate appreciation), where it falls primarily upon the non-mining tradable-good sectors to shrink and so act as the release valve.

A rise in the real exchange rate would undoubtedly have been necessary, but by shifting the balance and leaning against household consumption and borrowing, Australia would have improved its foreign debt profile (the net international investment position), its public finances would have been in much better health, and there would have been less hollowing out of tradable-goods sectors as a result of the boom.

We can’t fully judge Plan B until we’ve seen how the economy performs in the bust, which is presently unfolding. The key question is, will non-mining business investment and hiring rise quickly enough to offset the mining bust? It may yet do so, though the chances seem fairly slim. In my eyes, a greater emphasis on Plan C would appear to have been best option for the nation. Hopefully there’s another once-in-a-century terms of trade boom before too long so we can test that hypothesis!

RIP Restock

Leave a reply

Throughout the Great Iron Ore Rout of 2014, we’ve comforted ourselves with the knowledge that, regardless of what came beforehand, at least the fourth quarter would deliver respite from the market’s flagellation, as Chinese steel mills hastily replenished their depleted stockpiles of iron ore.

I’ve been something of a sceptic when it came the promised restock. Back in mid-September, my thoughts were:

I have been loath to commit to the point too aggressively, lest a strong Q4 restock befool me, but there are very good reasons to suspect that this year the iron ore rebound will be much more muted than it has been in recent years. We should still see a rally from current low prices by the end of the year, but the risks are heavily skewed to the downside.

I laid out a more detailed reasoning for this scepticism later that month:

India knocked some 100m tonnes of annual supply out of the seaborne market fairly rapidly in 2012 with its ban on mining in Goa, which followed similar restrictions in Karnataka in 2011 (total traded iron ore was about 1100m tonnes in 2012). If memory serves, Macquarie reckoned these moves added about $20 to spot prices throughout 2013.Chinese stimulus via fixed asset investment flowed freely in 2012, and, critically, the property sector commenced a strong upswing around the time iron ore bottomed.
Property is moving in the opposite direction now, and like much else in the Chinese economy, oversupply is becoming an issue. It remains to be seen whether the government is prepared to allow this process to run, or whether they cave and unleash another ‘big bang’ stimulus, as many analysts and commentators are now clamouring for. My base case is that the government institutes mild stimulus measures to support overall demand, without igniting another explosion of shadow banking excesses or wasteful fixed asset investment. But it’s roulette really, all you can do is monitor the situation in Beijing closely.
Due to a renewed upswing in Chinese demand, the loss of Indian supply tightened a market in which suppliers already held considerable pricing power. As everyone is surely aware, that is no longer the case now, with Morgan Stanley putting this year’s surplus at around 50m tonnes, growing to 150m next year. It has decisively shifted to a buyers’ market.
The displacement of high cost supply, which the majors adduce to justify their enormous supply expansions, will help stabilise prices in time. But so far this has occurred much more slowly than anticipated, and I expect this continue and high cost supply to exit only incrementally, rather than in a rapid manner that shrinks available supply and compels Chinese steel mills to suddenly scramble for stockpiles.

Thus, short of a ‘big bang’ stimulus from the Chinese government, the recovery in spot iron ore later this year is likely to be much more muted than in previous years. I still would not be surprised to see it rebound to around the high-$80s, but there is a good chance that the impetus for Chinese steel mills to restock as they typically did in the past just isn’t there now that the market is firmly in structural surplus.

Well, we’re through the halfway mark of Q4 and there is no restock in sight. Quite the opposite, in fact; iron ore has capitulated horribly.

And on the subject of capitulations, the sell-side is hurriedly accepting that iron ore is in serious trouble, and the downgrades are flowing freely. I noted with particular interest this comment from CommBank, included in today’s Reuters update:

“We no longer expect a meaningful iron ore restock later in the year as steel mills in China are content to purchase iron ore at their convenience, either from the port or from domestic producers, due to its wide availability,” Commonwealth Bank of Australia said in a note. “Tighter credit is also forcing many steel mills to adjust to lower inventory levels.”

This reflects the fundamental shift in the iron ore market that has transpired this year. It is obviously no secret that the sellers is now firmly locked in a chronically oversupplied market and fighting to the death. It was always likely that this change in the market would kill off the restock-destock cycle, or at least greatly reduce its impact on pricing. The reason being that steel mills don’t need to worry about losing access to supplies as they did when shortages reigned, so there’s little pressure to aggressively scoop up stocks when they have the opportunity in anticipation of tight supply down the track.

We’ll see buying before too long; these prices are surely looking enticing to some. But the shift in the market this year is structural, and we’ve got loads more supply coming next year. Any bounces into the year’s end are therefore immaterial, the sector’s fortunes are not going to be revived unless there is some radical shift in Chinese policy, and whether such a shift is even feasible anymore is debatable.