Australia: Playing with fire

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Please find below former Reserve Bank of New Zealand advisor and multiple CEO, Terry “Macca” McFadgen’s, latest ‘Maccanomics’ article, which tackles the reviving United States economy. Enjoy!

Australia’s recent history has been remarkably free of recessions. For nearly 20 years up to the global crash of 2008/9 the country clocked up regular growth. Call it good luck-call it good management, but it’s a fact.

In all likelihood that remarkable record is about to change because Australia has resolved to shoot itself in the foot. This it will do by contracting Government spending at the same time as other sectors of the economy are coming under heavy stress. If you follow events in Europe you will recognize this as the German disease.

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Let’s look at some high level numbers.

Recall that GDP is the sum of government sector spending (the fiscal deficit or surplus), household consumption, business investment and net exports. If all these components are shrinking then GDP must shrink. If only one or two are shrinking then that shrinkage must be matched by growth in the others if recession is to be avoided.

We know what the Government is going to do in the Budget for next year-it is going to show a small surplus because that outcome has been politically pre-ordained. We also know that the projected deficit for this year is about $40b and growing thanks to falling corporate tax revenues and falling GST. So, if all things remain equal, to reach balance next year the Government is going to have to cut roughly $40b from its expenditures. That equates to around 2.5% of total GDP of approximately $1600b.

Coincidentally, the whole economy is currently growing at around 2.5 % so, broadly speaking, that implies zero growth for next year unless one of the other sectors expands.

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Where will that compensating expansion come from? As Tim Colebatch of The Age has rather neatly demonstrated in a recent note this is something of a rhetorical question because to achieve normal growth of 3.0% next year in the face of a Government sector contraction of 2.5% you have to believe that if the Government maintained its current course the economy would grow by around 5.5% pa. In last year’s Budget the forecast growth rate for 2012-13 was 3.25%, and that is about the limit. Growth of 4% would be extreme. So a recession seems assured on these assumptions.

Of course when the Budget is tabled in May it will show a fiscal surplus and an economy that is growing at about trend rate of 3% because that answer is predetermined by the political calculus. Heroic assumptions will have to be made about tax revenues (including the new mining tax), the behavior of households, business investment, and productivity growth. All this will be done in the spirit of Yes Minister!

But you should not believe a word of it. The economy can’t cope with a fiscal contraction of that size and still grow-not at least without a huge dose of good luck. Here is why.

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Households are in Retreat

Household consumption (everything from food, to cars and dishwashers) accounts for the lions’ share of GDP at 55-60%. So what households do really matters. They spent like drunken sailors over five or six years from 2000, fuelled by debt backed by an ever-appreciating asset called the family home.

But that game is now over. House prices are falling (very fast in some places like the Gold Coast) and nationally prices are down about 7% over the past year in real terms. Of those who bought houses over the past two years about 2 in every 7 are now under water (negative equity) thanks to falling prices and high loan- to- value mortgages.

Households have reacted the way you would expect. They have put away their credit cards away and are saving like mad. The household savings rate has moved from a negative position (households spent more than they earned from 2000-06) to about 10% of disposable income. This is now roughly in line with historical norms.

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So to see a big boost to the economy from household consumption we have to see the savings rate decline. But why would it when in the background is this picture?

(N.Z. readers can also place their property on the red or orange line I’m afraid)

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Australian house prices remain roughly 40% overvalued on fundamentals and the banks, their overseas funders and, increasingly, households know it.

In recent weeks the head of Global Wealth Management for PIMCO (Peter Dorrian) has been in Australia and he gave an interview to the team at Business Spectator:

There is, he said, “quite a wide difference of opinion” between how Australian investors saw our banks (i.e. safe and sound) and how they were perceived off shore.” Its largely got to do with what you think is going to happen with the Australian property market…My colleagues in the US look at the Australian property market and say it’s the most overvalued property market in the world. To be honest, it’s a serious bubble…They have been looking at all sorts of different metrics that are used to standardise property markets around the world and they say that they think Australia is seriously overvalued in the residential space”

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Two years ago views like these were not heard in the mainstream media. It was left to the blog sites like www.macrobusiness.com.au to spread the word about the problem of over-valuation. Today the valuation problem is entering dinner party conversation.

For households, the anxiety prompted by fear of house price declines is being exacerbated by fears about security of employment. The sharp rise in the savings rate is highlighting Keynes’ Paradox of Thrift-if we all save we all go broke.

Currency exposed and consumer exposed sectors of the economy are hurting and layoffs are being announced regularly in NSW and Victoria. This contraction in employment is being counterbalanced by strong growth in the mining states, but it is unlikely to be enough. A rise in the national unemployment rate is not yet visible in the official statistics but soon will be.

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So for the 50-60% of GDP represented by household consumption, there is no obvious source of GDP growth and indeed there are reasons to fear contraction.

That leaves business as the lifeboat.

Net Exports & Business Investment

To cut to the chase we are really going to focus on mining, bearing in mind that iron ore and coal comprise about 50% of Australian exports and mining investment is booming.

Treasury places great store on the boost to GDP coming down the pike from an explosion of mining related investment. The headline numbers are huge and the potential boost to GDP is significant, for sure. Here is Treasury’s statement from last year’s Budget document:

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Mining investment has risen from $12b in 2003-4 to an estimated $56b in 2010-11.This is a precursor to an even larger surge over coming years as a range of large resource projects ramp up, led by the LNG sector. Mining investment is expected to reach a record high as a share of GDP over the next two years.

A pipeline of projects totaling $380b was identified!

The question is not about the grand list of projects that could be complied a year or two back but about how many see the light of day (or avoid deferral or scale- back) in the light of what is happening in China.

Here is a big call-the commodity boom which started a decade or so ago is now over. And that’s not Macca’s call- that is what the market is saying.

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BHP’s share price now sits at around a 25% discount to where it was trading a few years ago. That tells you a lot. In recent weeks one of the world’s largest equity investors (Blackrock), sold down its BHP position heavily because of fears that BHP was continuing to invest capital in expansions in the face of a looming China slowdown.

In fact, the China slow down is not “looming” it’s happening. The Shanghai Composite Index is now down over 60% from its highs in 2008 and that decline in the Shanghai Index is worse than the fall in the US Index during the Great Depression (1929-1933) when adjusted for inflation.

But the story is best told by looking at electricity consumption. Unlike China’s notoriously unreliable GDP data, electricity consumption is harder to manipulate:

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Note that power production is now growing at about 5% pa, year on year. The post- crash stimulus sent electricity production into orbit in 09/10, but that game is now up. Absent another stimulus, the days of 10% GDP growth inChinalook likely to be superceded by rates around 5%. The implications for our iron ore, metallurgical coal and thermal coal are ugly. So are the implications for mining investment.

JP Morgan recently asserted that China is already in recession. Whether that forecast is borne out by events or not we will know in a few months. More important is the underlying dilemma faced by China’s policymakers because how it is resolved will shape Australia’s future

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China’s Terrible Dilemma

Recall please that fixed investment (buildings, airports, railroads and the like), accounts for about 50% of China’s GDP. This is an extraordinarily high percentage, rarely matched in history by other countries in their development phase. Substantially all China’s GDP growth is accounted for by growth in fixed investment which the math tells us must grow in the high double digits to achieve GDP growth rates of around 8%.

But here’s the rub-about one quarter of fixed investment is accounted for by residential construction and it is widely acknowledged that there are now millions upon millions of unsold apartments on the ground. It would be” insane” to add to that surplus. So the other 75% has to carry an even bigger share of the growth load. But it too is looking overbuilt or at least fully built for current requirements.

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Add to that conundrum the problem that the major developed countries are in or close to recession-or are hostile to Chinese exports. So the prospects for growth in the Chinese export sector are very low indeed.

What to do? China could recognize the fact that its” high fixed investment/cheap exports” growth model has run its course and transition-with pain-to a model more reliant on household consumption. This is indeed what the World Bank and most Chinese economists recommend. But that implies a period of much lower GDP growth and a lot lower demand for Australian minerals.

Some of the best “on the ground” economists in China are skeptical that China can sustain rates of growth much above 4%-5% as its heavy reliance on fixed investment growth unwinds. Michael Pettis, who is based at Beijing University, is on the low side of the emerging consensus with a forecast of around 3% pa.

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Or China can decide that transitioning the economy away from fixed investment would put at risk the loyalty of an estimated 10 million party members who hold sinecures in and around the SOE’s (Macca relies here on an estimate by Prof. Minxin Pei from Claremont California). It could therefore decide to keep building infrastructure flat out knowing that it will face a massive banking crisis in a couple of years when it becomes obvious that the cash-flow from these new investments cannot support their debt funding.

These are ugly choices and will presumably generate ugly debates.

But here’s the thing – we have absolutely no idea who is going to be running China after the looming September leadership change over, and even less idea about what policies they might pursue. Maybe they will be serious about reducing the country’s reliance on fixed investment, or maybe they won’t.

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No-one in Australia knows and judging by the rumours of coups and leadership in fighting in Beijing, they don’t either. So let’s call this a 50/50 lottery which, if we lose, will result in a sharp decline in iron ore and coal prices, and a sharp rise in deferrals of mining sector capital expenditure.

Would you build a family budget around the 50/50 chance of winning a lottery? Of course not and nor should Australia build a national budget around such uncertain outcomes.

So What?

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If China is at risk in terms of its growth rate surely that supports the push for an early fiscal surplus in this year’s Australian Budget? Yes indeed says Macca that would be true if all other things were equal. But they are not.

Here’s the point: with house prices being so severely elevated the balance of risk is asymmetrical around a budget which cuts Government spending sharply. In plain language, if everything goes swimmingly Australia does okay-but if something goes wrong with demand from China,Australia suffers a potential disaster. In particular, it would suffer a sharp fall in house prices thanks to increased unemployment, a collapsing dollar, soaring fuel prices, and an expanding current account deficit. The RBA would pull all its levers but they take time to work and have inherent limitations.

All this would probably hit us just as another European sovereign-Spain, PortugalorItaly-was undergoing a traumatic debt restructuring. Funding forAustralia’s banks would come under pressure.

Action point – don’t play with fire by insisting on fiscal balance in 2012/13.

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The tragedy is that this situation is entirely self induced. First we allowed the biggest residential property bubble in the world to be inflated for nearly a decade, and now we are adding fuel to that fire by silly political gamesmanship. Australia can readily afford another couple of years of budget deficits. Government debt is low by world standards (30% of GDP).

Sure it would be nice to be in surplus after the biggest commodity boom in many generations. But that chance has now been lost. In years to come commentators will struggle to work out how we blew it, but we did.

Maybe much of this is now understood in the corridors of power and our politicians of both stripes have just been trapped by their own rhetoric. Maybe they will find some wiggle room before it is too late-Macca hopes so.

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Postscript

After completing this note Macca picked up his AFR this morning to find that the newspaper’s Quarterly Survey of Economists carries the headline ”Economists Say Don’t Wreck the Economy for the Sake of a Surplus” All true-but the die is cast I fear.

About the author
Leith van Onselen is Chief Economist at the MB Fund and MB Super. He is also a co-founder of MacroBusiness. Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.