The luckiest of countries by Leith van Onselen

The Reserve Bank of Australia (RBA) on Friday released a fascinating Research Discussion Paper entitled: Australia’s Prosperous 2000s: Housing and the Mining Boom, which formed part of The Australian Economy in the 2000s conference series.

According to the RBA, the paper:

…provides an overview of the Australian economy’s performance in the decade. Several key topics are elaborated on, including the development of Asia and implications for Australia, policy frameworks, and the opportunities and challenges facing the Australian economy, with a particular focus on the expansion of household balance sheets and the rapid growth in the mining economy.

After finishing the paper, I couldn’t help but feel how incredibly fortuitous we are as a nation, whilst also feeling uneasy about our future. Why? Because Australia’s economy has become increasingly undiversified and geared towards mining. At the same time, we have become highly dependent on one major export destination – China – which is fine while the Chinese economy is firing on all cylinders, but leaves us highly vulnerable should its economic fortunes sour.

For me, the most interesting (worrying?) aspects of the RBA’s paper are the following extracts, which I have supplemented, where appropriate, with additional charts from alternative sources.

First, the below section discusses Australia’s declining productivity growth, which currently is being masked by Australia’s record terms of trade (ToT):

One area in which Australia’s performance over the 2000s was less impressive is the growth of output per capita. While average real GDP growth, at 3 per cent, was roughly ½ percentage point less than in the 1980s and 1990s, growth in real GDP per capita was ¾ percentage point less than in the 1990s reflecting the stronger population growth in the 2000s (Figure 3).

Further, much of this growth in per capita GDP reflected greater use of factors of production: labour utilisation increased with the decline in the unemployment rate and the increase in the participation rate, while the pick-up in investment resulted in faster growth in the capital stock (Figure 4).

The relatively weak growth in output given the stronger growth in labour and capital reflects the marked slowing in multifactor productivity growth in the 2000s. In contrast, productivity growth, and so growth of GDP per capita, had accelerated in the 1990s following significant economic reforms.

While growth in productivity and GDP per capita were weak in the 2000s, this was offset by the large increase in the terms of trade, which resulted in faster real income growth.

Real gross domestic income (GDI) per capita grew at an average annual rate of 2.3 per cent, the fastest rate since the 1960s, and well above the 1.5 per cent average growth in per capita real GDP.

To put the increase in Australia’s ToT in context, consider the below IMF chart showing Australia’s ToT against other commodity exporting nations. As you can see, no nation has benefited as much as Australia from the China-induced boom in commodity prices.

And, as shown by the below IMF chart, the extra income derived from the commodity price boom has resulted in per capita Gross National Income (GNI) rising much faster than per capita GDP:

The RBA paper then contains an interesting discussion on the cause of rising commodity prices and Australia’s ToT – China’s (and to a lesser extent, Asia’s) booming economy – and what it has meant for the Australian economy.

Asia’s share (excluding Japan) of world GDP, at market exchange rates, has increased from around 10 per cent in 2000 to 17 per cent in 2010. Australia has prospered from this growth, both because of its endowment of natural resources and because growth in Asia means that there are now large economies closer to Australia than has previously been the case.

Industrialisation and urbanisation in China, and elsewhere in Asia, has greatly increased demand for resources, especially coal and iron ore for producing steel. China alone now accounts for almost half of global steel production. Australia is a major exporter of the key resources for steel production because it has large endowments of coal and iron ore, relative to a comparatively small population.

The below charts, which come from a different RBA paper, show how world steel production has boomed on the back of China:

And the effect of this extra steel production on iron ore and coal prices:

As well as export volumes:

Back to the RBA Paper.

In 2010, iron ore accounted for 17 per cent of the value of Australia’s exports, while coal accounted for another 15 per cent. This represented incredible growth, rising from 3 and 7 per cent of export values, respectively, in 2003…

The increase in commodity prices, and in particular coal and iron ore prices, has led to substantial efforts to increase commodity production. Since 2005, mining investment has increased from 12½ per cent of total private business investment to be around one-quarter. As a share of GDP, mining investment has increased from less than 2 per cent to around 4 per cent now, and with a significant contribution from liquefied natural gas (LNG) is forecast to increase to be above 6 per cent in coming years. Mining is more capital intensive than other industries and so, with a bigger mining sector, Australia’s capital-output and investment-output ratios have increased and are likely to remain higher than they have been.

Indeed, the increase in mining investment is a global phenomenon, as illustrated by the below RBA chart (taken from a separate paper). This suggests that significant extra commodity supply will hit the market over coming years:

The RBA acknowledges that the risk profile of the Australian economy has likely increased owing to the increased concentration in mining and reliance on one major export market (China):

The increase in the size of the mining sector is likely to make the Australian economy, and its fiscal position, more cyclical. Commodity prices are inherently more volatile than prices of services or manufactured goods because supply is typically less elastic in the short run and demand more sensitive to economic cycles. In addition, historically, the difficulty in forecasting commodity demand and prices, particularly at the long horizons of resource investment projects, has often led to over-investment and ‘hog cycles’.

The volatility of commodity markets is illustrated spectacularly by the below chart from Macleans.ca, which tracks the 10-year annual returns in overall commodities over the past 200 years:

Back to the RBA Paper:

In the period from 2004 to 2008, the strong growth in nominal income generated strong growth in tax receipts. This growth in revenue was used to fund significant cuts in income tax and increase transfer payments to the household sector, as well as to build up assets in a number of funds. While estimates of the structural budget position during this period are very sensitive to assumptions about the ongoing level of the terms of trade, most estimates suggest a deterioration during the latter part of this period, although the actual surplus remained around 1½ per cent of GDP…

Again, the below RBA chart, from a separate paper, highlights the budget revenue impacts from the commodity boom:

Back to the RBA Paper:

…the economy looks to have moved out along the risk-return frontier, particularly over the latter part of this period. Australia’s abundant supply of natural resources and its strong links with Asia have significantly boosted real incomes and have substantially improved the expected outcomes over the next decade. But along with the new opportunities and higher expected returns have come new risks.

During the 2000s, Australia’s international trade became more concentrated, both in terms of the goods exported and export destinations, potentially exposing the Australian economy to larger shocks. Over the past year, for example, exports of metal ores and coal have accounted for around 40 per cent of Australia’s total export receipts, and exports to Asia now constitute more than 60 per cent of Australia’s total exports, with Japan and China accounting for two-thirds of that. Further, an increasing share of exports is to emerging economies, which historically have had more volatile economic growth…

In the decade ahead, it is highly unlikely that the rise in the terms of trade witnessed in the 2000s will be repeated. This means that if living standards are to continue to rise at the rate we have become accustomed to, productivity growth will need to pick up significantly. For Australia to fully capitalise on the new possibilities, both businesses and government need to be focused on improving how things are done and addressing inefficiencies in regulation and business practices. If this does not occur and complacency bred by good economic times was to set in, then some of the benefits that now seem possible would fail to materialise…

The way I read the RBA discussion is as follows: Australia is incredibly fortunate to be endowed with abundant resources, which have showered the nation with riches as the Chinese economy has boomed. But over the past decade, Australia’s productivity performance has been poor, ranking near the bottom of OECD nations (see below RBA chart).

Australia’s over-reliance on mining and China leaves it open to a sharp deterioration in the ToT and a negative income shock should China’s economy ever hit a speed bump.

The ongoing mining boom, while welcome, cannot be expected to maintain Australia’s high living standards forever. Instead, we need to implement policies/reforms that offer to boost the nation’s productivity.

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