The mining boom’s balance of payments risk

Back in March I wrote a set of 3 posts to provide some macro-level analysis and clarity of the Australian economy in what I saw as the somewhat confusing view of our country’s financial position.  The confusion was being caused by the political rhetoric that our economy was world leading on the back of the mining investment boom yet many Australians didn’t feel that this was the case.

If you have time then please go back and read these posts, but in case you don’t the general overview was:

  • The mining boom is having a positive influence on national income, but its magnitude is insufficient to offset the larger outflows of interest payments and profits to non-residents as a result of over three decades of growth in external debt.
  • Private sector credit growth has been the major influencing factor in national income growth over the last few decades, but its rate of growth is slowing as households change their preferences towards saving over consumption after the GFC.
  • The government initially offset the private sector’s change in consumption preferences by increasing government spending. This has now stopped, as the government has set an agenda for surpluses.

As you may have noticed over the last couple of weeks there has been some commentary on MB, among other sources, about the over-strength of the Australian dollar, along with some concern about the continued strength of the mining boom and other economic indicators.

Although these events may appear disconnected, they are actually fundamental to what is driving the macroeconomic settings of the Australian economy.

As I have covered before, Australia has been running a current account deficit since the mid 70s. A current account deficit means that the country is a net borrower from the rest of the world. In that context Australia has continual net financial capital inflow to offset this deficit as we have tended to import more than we export in dollar terms for nearly 30 years.

Over the last few years Australia has seen a large improvements in the terms of trade due to rising global commodity prices. This has led to increased export revenue which has lifted the balance of trade. The following chart may, however, put that in some context:

As H&H has been actively covering, the prices of Australia’s major resource exports are now receding which in itself is beginning to turn the balance of trade back towards the negative. Trades in goods and services , however, isn’t the only part of the current account.

Australia has also until quite recently had a low level of private sector financial savings due to a high level of domestic investment. This has meant that the business sector has required foreign sourced capital to fund domestic investment and this in turn has increased the nation’s level of foreign liabilities. Due to this the country constantly runs a primary income deficit.

This income flow from foreign borrowings or equity investment is recorded in the financial account as these are seen as transfers of financial assets to foreigners. Although this inflow is positive for the economy it needs to be serviced. In that regard payments of interest and dividends on these investment inflows, the cost of borrowing, are recorded as a negative in the primary income account that is again a negative on the current account. This component also includes the repatriation of profits and dividend payments to non-residence.

At present, in order to balance the external accounts, Australia continues to increase its foreign liabilities via both portfolio and direct investment by non-residents. Obviously, the broad idea is that foreign capital inflows are used to create greater productivity which should eventually mean that at some time in the future the balance of trade will turn the current account positive, allowing for the foreign obligations to slowly be paid down.

The recent rise in commodities prices has led to period in which we’ve seen a positive balance of trade, but as you can see from the current account chart below this has still been insufficient to get the current account into positive territory:

As I stated above. the current account includes the repatriation of profits to foreigners. As the mining sector is mostly foreign owned as the sector becomes more profitable the payments to foreigners increase meaning that the positive capital inflows from the balance of trade quickly turn back into negative outflows through the primary account.  This is very much the dynamic that I think non-mining exposed Australia doesn’t see.

As has been a notable topic of conversation in recent weeks, the commodities boom along with international perceptions of Australia’s relative economic strength, continues to see the Australian dollar above parity. Amongst other things, these upwards moves in exchange rates reflect Australia’s strength as a global resource exporter, however, they significantly worsen the nation’s international competitiveness which slowly kills off other tradable sectors of the economy. This is the so-called “Dutch disease” effect. The side effect of this, along with the high dollars, means that local Australians increasingly purchase foreign goods and services which, once again, is a negative drag on the current account. This dynamic also has a transformative effect on the Australian economy, which inevitably becomes increasingly focused on the successful tradable sector and service industries that support it.

Now, you may be wondering exactly why I was prompted to re-post on this topic ?

Well firstly, I think it is important for Australia’s to understand the macro-economic drivers of their economy away from the political and vested interest spin. But secondly, and more importantly, there are an increasing number of stories in the national media about the pulling of mining related investment on the back of falling global economic demand.

So why is this so important? Well, what you may have realised from the above is that it isn’t so much the mining resources, but the initial capital investment that has been supporting Australian economic growth. The growing foreign capital inflows have provided increased national incomes and allowed the economy to continue to grow even though our foreign liabilities have also been increasing. That is, Australians on the whole haven’t been getting wealthier directly from mining, but from the services that mining requires in its initial expansion phase.

As this phase ends the capital inflows from mining will slow which in turn will begin to decrease national income. Without some adjustments in the current account, which as I explained above is structurally difficult given the ownership of the major tradable sectors, Australia is likely heading for period of economic stress.

Obviously there are many external factors that could turn this situation around including a renewed stimulus from China.

Comments

  1. That’s a great post. Agree totally, and I’m convinced that China will stimulate within twelve months, and at some point Australia will suffer the effects of years of economic negligence. Cheers

  2. You raise an interesting point often forgotten in the economic debate surrounding foreign investment. That those capital inflows that increase national income must be repaid with capital outflows that decrease it.

    It would be nice to have some national balance sheet accounting happening that would better capture what is happening with international capital flows.

  3. Great post DE. Easy enough to follow so why is it not more widely understood.

    I also am concerned specifically about foreign CBs buying Aussie govt debt. These funds are not being invested to ensure that repayment can occur but rather are being expended or end up as some home buyers debt. To leave Australia open to taking on liabilities the numbers show cannot be repaid is highly negligent

  4. GunnamattaMEMBER

    Good to have that post again. It seems weird but my gut feel is that not many people get this point.

    I agree that Chinese stimulus will turn things around, but only in the short term, insofar as for Australia it would only delay the reckoning – to some point further down the track, when the pernicious impact of wiping out non mining import competing-exporting sectors has gone that bit further – of Australia relying on one sector alone and being essentially non competitive on almost every other.

    I tend to see other global CBs buying AUD assets as actually embedding this uncompetitiveness. The dollar will tend to greater inflexibility with a load of CBs hanging off it, and if it remains inflexibly high for this reason then that just underlines the message to non mining import competing/exporting sectors.

    • “…global CBs buying AUD assets as actually embedding this uncompetitiveness”

      Well this is what has prompted McKibbin and even the RBA to voice concern. But don’t let the high AUD meme obscure the fact that much Australian manufacturing has been moving offshore for decades, just as it has in many other developed nations.

  5. DE, you already know I agree with you – more of your posts on the Australian economy would be welcome.

    And because it would be remiss to omit and indeed it is expected: To all those that can’t wait to see the end of the boom – be careful what you wish for.

    • Absolutely!!!

      However I guess those wishing the end of the boom are those who see themselves as absolutely immune to any correction in their own circumstances that the end of the boom would entail.
      As usual the pain will be borne by the few although it will be a few more few than in previous times.

  6. DE, a question from a nonspecialist – the modulations in the CAD are a direct function of the world economy it appears, every Gfc-type event results in a reduction of the CAD. Am I right here, or do I have the timing wrong from the graphs?

  7. Thank you DE!!! Exactly!!!

    Sorry I always ‘correct’ you here. This damned CAD has been running since 1959. Just from memory 1971 was the only year in which we have run a small CAS.

    My economically conscious life now extends some 49 years and I’ve been watching the CAD grow continuously through all that time. We have ALWAYS been accepting Foreign Investment with the view that it was funding development that would turn into a Current Account Surplus. It NEVER has and never WILL.
    We have always spent the Foreign money borrowed or invested on consumption.

    “The government initially offset the private sector’s change in consumption preferences by increasing government spending. This has now stopped, as the government has set an agenda for surpluses.”

    I got a bit of a laugh from the ‘this has now stopped’ part. The Govt PROJECTS, on the basis of wild optimism, that it will stop. I don’t think it has ACTUALLY stopped. (I’m open to correction!)

    (Webspyder and Sweeper et al please take note of DE’s writings on the CAD. This directly relates to our discussions re interest rates)

    • Flawse,

      Following on the interest rates discussion – The way I see it, high interest rates and an overvalued currency are two sides of the same coin. I can’t see how people who advocate higher rates can also advocate a lower dollar.
      Take into account that:
      1. The world interest rate is currently 0% (and we have no control over this)
      2. We are a small economy, open to capital flows in and out.
      3. The currency is currently estimated to be overvalued by about 40% on a PPP basis.

      Ignoring risk premia, foreign investors can only be willing to hold AUD bonds vs home bonds (given the expected depreciation of the AUD implied by the current overvaluation on PPP), because they are being compensated with a high interest rate differential. So, increasing interest rates is just an opportunity for investors to further bid up the AUD.

      But it’s worse than that; because currencies are known to overshoot (and actually have to overshoot) small increases in interest rates will cause an exaggerated increase in the AUD.

      On the BoP: I can’t see how high interest rates are consistent with a smaller CAD either. The short run effect of increasing interest rates would be to widen the CAD for 2 reasons. 1. Net capital inflows would increase, raising the real-exchange rate and reducing net exports & 2. A greater interest rate differential would mean a wider net income deficit.

      • Sweeper

        This is where things get confused!!!! You are operating on current economic free market at all costs orthodoxy.
        Now I am more than aware of the difference between what ‘should’ happen and what WILL happen.
        So my full argument includes a call for abandonment of modern orthodoxy. In my view it has all grown out of the USA which has operated the Reserve currency. I include Magic Pudding Economics in this field. It’s little different to other load of modern tripe.

        We need to re-think. Yes you are right. In the modern world high interest rates equal high dollar…until it doesn’t but I’m not sure where that point is.
        I’ve consistently argued, and have done publicly for some 46 years, on and off, for control of Foreign Investment. Note the word is ‘control’ not banning. I’ve argued for control of the Hot money flows. I’ve argued for at least a balanced external account and all that entails including savings.so that we don’t have to sell off our resources and industry

        I have NEVER claimed the answer will be easy or that we attain perfection but hells bloody bells someone tell me something that is not worse than our current situation that is driven by all schools of modern economic drivel!

        Sweeper we may not be as far apart in our ideas as you think.

        I think we need to decide what we are aiming at for OUR country. At the moment we are letting our people be destroyed by CB’s and economic theorists far from our shores with no interest whatsoever in the long term well being of our nation.

        High interest rates SHOULD TEND to cure a CAD because you get higher savings and less spending. Of that marginal spending a high proportion of it is imports. Now sure classically high savings lead to a higher dollar…disaster. That’s why we must abandon all this stupidity!

        Having said that i need better brains than mine to be working on the problem. I’m just trying to frame our circumstances properly.

        Otherwise what is the answer???????
        Lower and lower rates, more consumption, more debt, more foreign debt, more asset sales to foreign interests?
        What happens when we run out of stuff to flog off to maintain our outrageous standard of living?

        What I am proposing is not optional. It must happen eventually. The (easy?) answer lies back in time. There will be massive dislocation from all this eventually. It would be a lot better if we played a few cards while we still hold a couple of Jacks!!!! The Queens Kings and Aces are long gone.

      • Sweeper
        Just one more thing. We also need to look at the effect of modern economic orthodoxy and interest rate policy in terms of world resources.
        Negative and Zero RAT rates lead to massive credit creation and over-use and waste of resources. We live in a finite world and this all has to stop.

        Imagine how much less consumption there would be if, theoretically, every time you wanted to over-consume by borrowing you had to go somewhere and persuade some other bloke to under-consume.

        At the moment zero interest rates presume that you can print unlimited money to create unlimited consumption in a world with finite resources.

        Sensible economics would make a whole better world…naturally!!

  8. Jackson

    When recessions hit spending slows. This thus cuts imports. Discretionary spending, in Australia’s case anyway, would tend to be a higher proportion of imports than for spending as a whole. This would tend to emphasise the reduction in imports.

    Note the reverse also applies. The response to either lowering interest rates, or Govt deficit spending, results in quite a high proportion of the resulting increased spending being spent on imports.

    Call it a ‘high propensity to import’!! 🙂

  9. DE
    I’ve asked this question before..or perhaps made this observation wanting your thoughts.

    My impression, over a long period, is that while repatriation of profits proceeds apace, a large proportion of profits has been re-invested here especially in the mining industry. Therefore we understate the CAD by the amount of Foreign owned company earnings that are retained here.

    I think this would be a very significant number.
    It also means that as the investment boom matures the increase in repatriation of foreign company earnings is likely to be exponential rather than linear. Obviously this spells more trouble on the horizon.
    Unfortunately almost nobody is looking that far.

    • While this is true, flawse, the pie is growing at a faster rate than our share of it is diminishing. It is just that, as you say, we prefer to spend the increased income from our share of the pie on consumption, rather than buying back some more pie.

  10. Alex

    The measurement of the size of the pie is, at best, dodgy. It seems not too many of us are feeling so much better.
    As per my question re the retention of foreign earnings the high value of the currency is giving us a false measurement of the size of the pie. Further we are counting a whole lot of things that are either non-productive or actually negative to production as real production. The whole concept is screwy.

    Secondly there are lots of long-term lags in here. It would take me a while to try to explain but the coming decades will reveal the price. We have squandered our prosperity and it will be others turn to benefit from their hard work and savings.
    Anyone thinking the next 5 decades are going to bear much resemblance to the past five has their head in the usual place.

    • I have to agree with you on pretty much all your points. My comment was aimed at pointing out that we have indeed squandered yet another opportunity to rebuild our share of the pie. Looks as though we, along with most of the developed nations, will continue to do so until it is no longer possible.

  11. Alex thanks for the clarification. You’re right and at this age and stage of disillusionment I find it quite sad.
    You’re also right on the fact there is no will whatsoever to fix it.

    “Looks as though we, along with most of the developed nations, will continue to do so until it is no longer possible.”

    Exactly!

  12. What options are there to get the current account to zero or surplus ?

    More saving, more exports, import replacement ? Or should we be buying overseas assets while the AUD is high and then selling when the AUD falls ?

  13. Neznam

    This has been hashed a fair bit around here. You cannot realistically buy overseas assets unless you run a Current Account Surplus. Suppose you print up dollars to buy overseas assets. Lets presume they are accepted as they would be at the moment (hence McKibbins proposal. It would tend to force the currency down a bit. However the new holder of the A$ can send then straight back here to either buy our assets or park here. Either way they have to be mopped up which means a rise in the A$….back to square one!

    The only way to get to a surplus is either to produce more or spend less or, most likely, a combination of both.
    If we are to consume less then we need higher interest rates. Under current economic idiocy this would then lead to a higher dollar…the stupidity goes on and on.
    Our chances of ‘producing’ a whole lot more don’t currently look likely and, even if we did manage that and the favourable terms of trade are maintained forever, we would just consume more. That’s the way Australians seem to want their country run.
    Everything is ‘me! now!’

    There is no way out of this. Of our industry that has not already been sold to foreigners we are busy dismantling with a combination of stupid unrealistic laws and a high dollar. We can’t just get it back as soon as we think we want it. Our education system has been focused in the wrong direction for some 20 odd years now and most of the technical education required for any sort of re-balancing is gone.

    As Alex said this insanity is going to on and on ….until it can’t.

  14. just a question then of when TSHTF…

    Anyone care to put a range on the time frame?

    And of what this will mean domestically in terms of unemployment, value destruction and government budget surpluses over the next 5-10 years?

    • And the AUD?

      How does this sound?

      >10% unemployment (not in real terms but in government fudged numbers)

      House prices down 30-50% from current levels

      25% of GDP budget deficits, even with an axe taken to middle class welfare

      AUD = USD60c

      Or am I barking mad?

      • Nope. You’re probably pretty much on the money. The most unbelievable aspect is that a hefty chunk of MB readership actively agitate for one or more of those outcomes under the delusion their particular preference can occur in isolation.

      • 3D, no chance the preferences can be isolated, this is a crash and burn scenario where cash will be king and debt a chronic disease the middle classes and the speculators can’t be cured of without a massive doses of inflation. But that’ll bring the kind of malaise and pain we normally associate with chemotherapy – to kill the cancer we need to all but kill the patient…

        There is another way, but with our political process a defunct joke captured by vested interests I am not holding my breath to find out if we as a nation have any clue about rediscovering reality.

  15. I like this post – but what is the answer?

    perhaps use our high dollar to buy foreign assets?

  16. Rhett…refer above.

    mikey

    I agree that should tshtf your numbers are probably correct…well once you are in that area +/- 50% won’t be a major issue! We’re just talking ‘Is it a monstrous disaster or is it a monumental gigantic disaster?’

    Mind you if commodities fall 60c for the dollar might be optimistic. Imagine the inflation! Then what would interest rates be??? Thinks again and you are probably too optimistic to join my club! 🙂

    However what will and should happen are generally two different things. So I think we will go along on our current path with our situation steadily deteriorating as we go. Tshtf may take a while to come to pass although the distance between the rock and the hard place is sure getting smaller and smaller.
    In Aus case my bet, today :), is, that with China et al wanting to divest themselves of paper USD the foreign capital flow will continue. So we will miss a greater part of the deterioration in assets that most of the rest of the developed world will suffer. However inflation is not far away. Once that starts ANYTHING could happen and probably will.
    So contrary to most here I’m about to take on a little debt and buy a bit of Gold Coast RE. Sounds stupid I know but I have family imperatives that are at work.
    However my thinking is that when the crisis starts all CB’s including our own are just going to print on a scale heretofore unimagined.

    That’s my two bob’s worth. Any opinions welcome. I’m sure as hell not wedded to any outcome!
    One thing I do know is that it is a knife edge we are on and 99.9% chance of falling off one side or the other.

    • Flawse,

      You have to laugh. I had dinner with the global head of credit markets for one branch of Mega Bank (friend of my wife) a year or so back. He said he couldn’t believe he’d met someone more bearish than him. I mentioned zero hedge, he said he’d banned his traders from reading it because of its relentless negativity. I countered, saying I wasn’t bearish in the slightest, I was only observing reality. He made a comment that in his game it was about having to keep dancing while the music was playing, no choice on that score. I suggested that reminded me of the post-iceberg, still floating Titanic. It was a fun dinner, a nice and smart guy, also beating himself up about having just bought a waterfront mansion when he knew what was facing the property market. If ever this was a case of bipolar cognitive dissonance…

      An amusing aside, while visiting the Napoleon exhibition at the Art Gallery yesterday I was struck by the fabulous portrait of Marie Antoinette and the excess of appropriation that the emperor and his cronies (and before them Louis and his clan) had undertaken. One does wonder where our mob mentality will take us when TSHTF…?

      So as for your points, yes yes and yes. If and when inflation takes hold I’ll be into the property market, mopping up somewhere comfortable that a prior fool paid far too much for, after all I too need a place to live and raise my young fella. China, like us, is facing rock v hard place choice.

      There are no good solutions, only less worse ones and to paraphrase Winston Churchill’s comments about the yanks “they do the right thing after having exhausted every other option”, just a question of when and how bad, not if we catch the falling knife.

      • Thanks mikey…got a good laugh.
        Unfortunately your friend is right re banks having to dance as long as the music continues. There is not a lot of future, as a banker, roaming around saying there will be nothing worth investing in for at least the next 10 years.
        I have a member of my family in that position. He thinks he might retire and have a good for 10 years and live somewhere really cheap then have another look in 8 or 9 years time.
        Mind you it is my son so there may be a heretability factor involved.

        Thanks for the feedback re inflation. My ideas on the future are a long way from fixed in stone particularly as to timing.

  17. P.S. A fair percentage of my ‘liquid’ assets are in Gold and have been for a long time. Other than that I’m invested in a few mines I hope will be flogged to the Chinese. Then my main business is importing for the retail recreation industry!
    That’s a fair spread once I add in the GC RE!!! 🙂
    Maybe one strategy will survive!

  18. flawes,

    the govt can raise funds at 3.5% – and can buy for example a US pharma company. there is no reason to print money

    • Rhett…oit reduces the money supply here onnly if you SAVE it and then pay it Yes? So to save it we need to raise interest rates…and so it goes.

  19. At the moment the Govt is raising funds at 3.5% mostly from offshore. However suppose it can raise money here at 3.5 currently it is raising money to cover its deficit. So the net saving would be zero and no funds are available for overseas investment.
    In order to run a CAS we need to save as a whole nation i.e. combined Govt sector and private sector which includes both household and business.
    In order to do this we need to raise taxes or interest rates. Our situation requires both.
    I’m not saying it is impossible be done but you have to put up with attendant economic social and political devastation.

    • The other aspect to that Flawse is by raising interest rates , taxation etc you will get a stronger dollar, a non virtuous circle.

      We need to revisit Keatings original vision of super for the nation. The pool of funds that purchases overseas assets and offsets the CAD.

      We need to buying the Swiss and Chinese assets that they have bought from us.

      • Yes Jack…Under current economic orthodoxy you are right. Fair to say I don’t hold much truck with it. It was an American specific idea and it has failed throughout the western world including the US.
        Buying back our own nation would be the first priority. Not sure how it can be arranged. If the Govt or big Super Funds run it I’m not sure we’d get a great outcome.

        The problem with Super is we had our cake and eat it too. The Super contributions were, generally speaking, just added to wages over time so all we managed was to make everything more expensive. We were spared the pain by the high Australian dollar!!!! Unfortunately real Super saving means a real sacrifice of income not some pea and thimble trick as has played out here.

      • Flawse I thought of you when the Liberal Discussion Paper on foreign investment was released – do you have a view?

      • By that I meant I have not seen it yet but my expectations would not be high.
        I’ve seen reports but I don’t trust the media.

      • Yeah unfortunatly the super industry has been taken over and dominated by special interests, the industry funds by the union movement,and its looks like the SMSF sector is being increasing influenced by the housing industry.

        I think Keatings original concept was right, but it all started changing about 1996/97.

        It was interesting re the asset allocations of super leading up to the 2001 tech wreck. International equities had enjoyed good performances and subsquently , large amounts of our domestic super money headed offshore, our dollar dropping to 50 cents by memory.

        Interest rates were higher as well than now.

        People dont have enough faith in the super system now without the authorities mandating asset allocation, and that would open a can of worms.
        We could see all sort of politically based permutations of asset allocation arising.

      • 🙂
        “I’m from the government. Just give me your money. it will be safe. NO ONE will ever be able to get it”

        I agree with all your sentiments

  20. Your feedback loop in the current economic lunatic orthodoxy is that the process would result in a substantial rise in interest rates…feeds back to the dollar etc etc etc round and round!