Ken Henry’s lucky country

On Friday evening, Treasury boss Ken Henry delivered his final public address before stepping down in March. At the University of Tasmania Giblin Lecture, Henry delivered his magnum opus, a broad review of Australian economic history spanning three centuries (full transcript below, h/t The Lorax).

The document is a must read in full, but the pivot of the speech is Henry’s use of the sweep of history to argue “the case for optimism” on Australia’s economic future.

The mining boom is the most remarkable consequence for Australia of the rapid growth of China and India.  Many commentators, in Australia and elsewhere, have expressed concern about our economy appearing to be so heavily dependent upon continued Chinese demand for our natural resources.  What happens when Chinese growth slows down or, even worse, collapses as Japanese growth did at the end of the 1980s?  What happens when global extraction of mineral resources catches up with Chinese demand and commodity prices collapse?  And what if, when these things happen, we find that we have “hollowed out” our manufacturing sector and have nothing to fall back on?

These are understandable, if somewhat bleak concerns.  But I would suggest that they are exaggerated.

This blogger noted recently that Treasury is in danger of exchanging a defunct one-eyed growth narrative – the Pitchford thesis – for a new one-eyed growth narrative, endless Chinese demand. It is a relief therefore to see the possibility canvassed that China may not grow in perpetuity.

Having broken the seal on this question, let’s see what Henry does with it:

Indeed, there is instead a strong case for optimism. At the end of the 1980s, Japan was our largest trading partner.  After 20 years of poor macroeconomic performance, characterised by several recessions, Japan remains our second most important export destination – only very slightly less important than China, despite that country’s stellar economic performance.  For the Australian economy, Japan remains a very big market, even when it is growing slowly.  A weakly growing Chinese economy would present an even larger market than Japan.

OK, given we’ve been invited to, let’s try to quantify, at least roughly, what a slowdown in Chinese growth would do to Australian exports. Every miner in the world is currently investing huge sums into expanded capacity. BHP’s $80 billion schedule is one example. Or take Rio and its myriad ore expansions including the Pilbara, Orissa in India and Simandou in Guinea.  These firms are not expanding capacity on the presumption of a stalled China.

And if it does stall, the prices for all the metals with all customers will fall, not just China. Which explains in reverse why exports to Japan have continued to grow over the last decade despite a lacklustre economy. That growth has largely resulted from the rising price they’ve paid for raw commodity imports because of Chinese demand, not because their own volumes have been growing strongly.

As a hypothetical, let’s say China slowed to permanent annual growth of 6% and the prices of  iron ore and metallurgic coal found a new equilibrium 30% below ABARE’s projected 2011 totals (which is still historically high). Even if volumes were maintained, it would punch a $30 billion hole in Australian exports. And similar would happen to all base metals and soft commodities.

Let’s go back to Ken Henry:

A second observation is that, given the very long term trends in industrial structure that we have already observed in the past half century – with services growing strongly as a proportion of total employment and manufacturing employment falling from about one-third of the labour force to less than 10 per cent today – it is a bit odd to be referring to this as a China-induced “hollowing out” of manufacturing.

Henry himself admits early in the address that the mining boom has accelerated the decline in manufacturing so we needn’t labour the point. Suffice to say that in the last six months the world economic recovery has been driven by manufacturing booms across Asia, Germany and US, whilst Australian manufacturing shrank for six straight months. On top of that we had the recent disastrous capex projection figures for the year ahead. That is evidence enough of manufacturing’s intensifying struggle.

Elsewhere in the speech, Henry also praises Australian manufacturing’s proven flexibility and no doubt it would bounce back if the dollar fell. But as Henry says himself, the structural decline offers little prospect of any offset if commodities correct. Henry goes on:

A third observation goes back to the points I was making at the start of this address, concerning the consequences for industrial structures of real incomes growth associated with economic development.  Today, we see China as a manufacturing powerhouse, reliant upon raw materials that we happen to have in abundance.  But, at the Chinese economy develops, its industrial structure will also change.  It won’t become a smaller producer in manufactures in absolute terms.  Indeed, Chinese manufacturing output will probably grow at least as fast as the Australian economy grows for as long as any of us can project.  But other sectors of the Chinese economy will grow even faster, in time.  As with all other stories of economic development, real income growth and the emergence of a large middle class will generate a demand for an almost endless variety of goods and services.  What sorts of goods and services?  Who knows?  It could be premium tourism, it could be fine wine, financial services or it could be some other good or service not yet invented.

At other times in our history we have witnessed some of the opportunities that income growth in emerging markets presents for Australian exporters.

Consider tourism services, for example, and the strong Japanese demand that drove its development.  With increased demand for tourism services from emerging markets, there is considerable potential to attract a greater share of increasingly wealthy travellers to Australia for business tourism, holiday packages and to visit family and friends.

According to the United Nations World Tourism Organisation, the number of international tourist arrivals globally reached 935 million in 2010.  That’s an increase of 58 million, or seven per cent, from 2009. Emerging economies continue to drive global outbound tourism expenditure growth — for example, 17 per cent for China in 2010 — outstripping growth in traditional markets like Japan, the United States, Germany and the United Kingdom.

Australian tourism stands to benefit from these global developments.

We have also already seen a greater appetite for particular goods produced by Australian exporters.  For example, while Australia’s largest wine export markets continue to be the United States and the United Kingdom — and while there is currently pressure on this industry from the high exchange rate — wine exports to China have grown strongly, increasing from 1.9 per cent of total wine exports in 2007-08 to 6.1 per cent in 2009-10.

Back to our hypothetical, could Henry’s exporters of tomorrow make up the $30 billion plus black hole?

The argument that tourism stands to benefit in the years ahead has good evidence. If we refer to the DFAT Composition of Trade report, we can see that tourism and education make up an rougly two-thirds of Australian services exports.

The growth in China’s imports of Australian services has been very impressive too, rising from third to first in the past three years:

DFAT doesn’t break up China’s services imports by category but it’s a sure bet that its dominated by education and tourism, just as it is with the rest of the world.

But put the two graphs together and the positive story starts to fray. I mean, if education and tourism are so dominant, what’s left to benefit from China’s move up the value chain?

Japan is again a painful comparison. Check out the table of Australia’s services exports to Japan, down three year’s running. If China slows similarly, and moves up the value chain, the experience of Japan suggests services will play little role in boosting Australian exports.

Henry’s other example, wine, is no better, earning Australia a little over $2 billion in 09/10 with ABARE projecting more falls for this year.

Finally, this blogger will ask that if the departing Treasury boss is so optimistic about Australia’s ability to maintain strong enough exports to sustain its income and standard of living in all future circumstances, why did he risk his career last year overseeing a tax review that included a resources rent tax aimed at funding a five per cent cut in general corporate tax rates, as well as a raft of small business concessions?

If that’s not concerned about hollowing out, over-reliance on resources and Dutch Disease then what is?

50055383 Ken Henry Giblin Lecture

Houses and Holes

David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the fouding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal.

He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.

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Comments

  1. My 2c worth…

    Henry says “Today, we see China as a manufacturing powerhouse, reliant upon raw materials that we happen to have in abundance”.

    China isn’t reliant on our raw materials for manufacturing, China is reliant on our raw materials for its infrastructure building boom … much of which is unused or unoccupied.

    Henry says the long term trend is a shrinking manufacturing sector and growth in services, and “it is a bit odd to be referring to this as a China-induced “hollowing out” of manufacturing.”.

    The hollowing out isn’t restricted to manufacturing, its across the trade-exposed non-resources sector, that includes service exports like education and tourism.

    Henry says “other sectors of the Chinese economy will grow even faster” but the evidence shows consumption as a share of China’s GDP is shrinking not growing, and post-GFC China has become increasingly dependent on fixed asset investment to maintain growth. While investment is strong, the AUD will be strong, and our ability to sell non-resource exports into the Chinese market will be constrained by the currency. New Zealand will be a far more attractive prospect to the burgeoning Chinese middle class for fine wine and tourism.

    Henry says “with increased demand for tourism services from emerging markets, there is considerable potential to attract a greater share of increasingly wealthy travellers to Australia for business tourism, holiday packages and to visit family and friends.”

    What is Ken smoking? Does he know what’s happening with Australian tourism? Perhaps he needs to spend a few weeks in FNQ!

    • Re: China’s Investment.

      Where did you get your Data?

      Check out China’s official investment in fixed assets by industry for Nov 2010.

      http://www.stats.gov.cn/english/statisticaldata/monthlydata/t20101228_402694251.htm

      Maybe Dr Ken Henry is talking about how China’s growth of 18.4% in Total Retail Sales of Consumer Goods from same period previous year.

      http://www.stats.gov.cn/english/statisticaldata/monthlydata/t20101227_402693587.htm

      Sure QLD tourism and especially FNQ is suffering.

      However, Maybe he is talking about how the Chinese Tourism sector grew ~12% with the Chinese population expected currently to make 51 million overseas holiday trips.

        • So fixed asset investment is growing at mid-20s to mid-30s, consumption is growing in at 18.4%. Result: the consumption share of GDP is falling, the investment share of GDP is rising.

          Read Michael Pettis.

          (The real estate number is eye-popping BTW. No bubble here, move along, move along)

          Chinese tourism might well be growing rapidly, but Australia won’t be top of the list of destinations while China’s investment boom continues, keeping our exchange rate strong.

          • Come on The Lorax

            Read Jim Rogers

            “Jim Rogers : Well, the only asset bubble I see potentially in China is in urban coastal real estate, but real estate is not nearly the entire Chinese economy as it was in America and the U.K. Sure, they will have setbacks.”

          • No, construction and real estate represent a much larger share of Chinese GDP today than the US or UK in 2007. At least double, perhaps triple, and still growing at 30% plus.

            Read Chanos.

          • The Lorax,

            I am waiting for Robert Shiller’s comments about China, if he calls China a bubble then it must be a bubble.

  2. I’ll go through the text of Henry’s speech… but the newsclips that I saw suggest that it would be well worth watching a podcast of the speech if one existed as he made a few quality, off the cuff, comments… such as essentially saying that Australians have become more apathetic since the 80s and have not been applying enough pressure to force better policy decisions from politicians… I’d agree whole heartedly with that!!!

    • As Henry observes, the growth of the ‘service sector’ (a misnomer in the modern age if ever there was one) has continued apace for decades.

      What Henry fails to observe is that the growth of the service sector has resulted in a major shift from a balanced export sector to one running a massive Current Account Deficit.

      As a result it has resulted in
      a) the destruction of the social end economic structure of rural Australia. The ‘Dutch Disease’ is nothing new. We gave ‘Dutch Disease’ to rural Australia back in about 1960.
      b) the sale of vast tracts of our best agricultural land, almost all of our significant secondary industry and approximately 80% of the mining industry to Foreign interests.
      c)Dsspite the sale of most of our assets we still carry a NET external debt of about 70% of GDP.

      The fact that this has occurred consistently over a period of 50 years does not make it any less of a fact, nor any less significant for our future. In fact, it means the situation looks basically irretrievable since the answer lies 50 years ago in time.

      The only ‘solution’ that we are condisering is the sale of whatever assets we still own at an ever faster pace.

      The ‘service sector, in the case of most ‘western economies” is not symptomatic of an advanced economy. It is symptomatic of a debt-laden economy.

  3. It’s a must read, for sure. And it’s full of quotable stuff. I picked the bit I did because it was the general thrust of the speech to debunk any concern over Dutch Disease, which struck me as bizarre given the Henry Review…

    • A very good point and after a decade of a massive China boom (industralisation evolution) Treasury has only just got on board with the concept but then go completely over the top and maintain the boom is going to go on for another happy decade or two. There seems to be little consistency and as many commentators here agree there’s no contingency plan in place if the boom doesn’t continue as forecast or even a plan to boost the country’s economic structure to withstand inevitable “black swans”.

      Its very disappointing but then if we follow the money, Mr Henry will happily retire on a nice fat Govvy indexed pension for the rest of his life – no mercy of the markets for his superannuation !

  4. Lorax,

    I fairness, I believe Henry is referring to the non-resource sectors that have potential in the event that China slows and the dollar falls.

    Seems to me there is something in the argument that tourism and education are more flexible than manufacturing. If a factory closes and a supply chain is lost, that’s harder to recover that services…

    It’s the magnitude of the dependence on resources that I think Henry finesses.

    • Fair enough, but as you say, even if the dollar falls fine wine exports to China ain’t gonna fill that $30 billion hole anytime soon. Seemed to me he was clutching at straws, trying to find something, anything, that would support his argument, and the best he could come up with was wine?! Just made him look silly.

  5. Re Lorax “What is Ken smoking? He’s not.

    Kommo Ken from Kyogle. Kyogle is an old timber town in Northern NSW. What you read is pulp fiction from a bloke with a chip on both shoulders.

    Ah, the divine right of taxation to keep the public services (local, state, federal) in the lifestyles that they have become accustomed to.

    And who is going to pay for our servants lifestyles if China has a commodity flame out?

    So much dross and no matches.

  6. Nicolas, this is for you:

    From Michael Pettis latest newsletter…

    But not easy. Let’s do the math. The household consumption share of GDP was above 50% in the 1980s but declined slowly to a low 46.4% in 2000. Thereafter it all but collapsed to 35.1% in 2009 (I have already explained why I think this was a consequence of the banking crisis at the end of the 1990s).

    This shouldn’t have been a surprise. Household income growth sharply underperformed GDP growth in the past decade as well.  Although the 2010 data has not released yet, there is reason to believe that household consumption number is likely to clock in around 35-36% of GDP. The National Bureau of Statistics announced on Tuesday that urban and rural household income grew by 7.8% and 10.9%, respectively, sharply lower in the aggregate than GDP growth. Under those conditions it is reasonable to assume that consumption growth did not keep pace with GDP growth either.

    If over the next five years consumption is going to grow from 35-36% of GDP, its current level, to 40-50% of GDP, then consumption growth will have to outpace GDP growth by anywhere from 2.9 to 7.9 percentage points. So if China indeed grows over the next five years by the 7% predicted by Premier Wen, consumption has to grow by anywhere from 9.9% to 14.9% annually to get China to the target.

    That’s going to be very hard without a significant change in corporate governance, i.e. a massive transfer of wealth from the state to households – which may be just another way of saying “privatization”, which is not (yet) on the cards. Even when GDP was growing at 10% and more, consumption growth only averaged 7-9%. Somehow without a major structural change in the growth model we are planning to lower GDP growth sharply while raising consumption growth to levels never before seen in Chinese history. Of course if GDP grows at 8-9%, which many people still believe, consumption will have to grow by a minimum of 11-12% just to get us to a 40% consumption share.

    Its theoretically possible, of course, but unlikely.  Far more likely is the Japanese route – slightly slower household consumption growth and much, much slower GDP growth. If household consumption grows at 7% annually for example, and GDP grows at around 4% annually, by the end of the five-year period household consumption would be around 40% of GDP (which only five years ago was already considered astonishingly low).

    Take your pick. If the trade surplus is constant and investment growth flattens out, either consumption growth has to surge to levels never before seen in history, or GDP growth must slow sharply. If the trade surplus declines, we need an even more extreme choice. Most importantly, if Beijing is successful in slowing investment growth, all of my numbers will be wildly optimistic.

    Of course Beijing can simply keep jacking up investment levels. But who will pay for all the waste? The household sector of course. In that case what prevents consumption from declining even further? I have no idea. The problem with arithmetic is that there is no way to add two and three and get seven or eight. The damned equation always adds up to five.

    So Nicolas, you tell me, how does China transform from an investment-led economy to a consumption-led economy?