Australia stands to break its 'boom-bust' cycle

September 14, 2012, 12:32 pmCNBC

Australia has a sorry history of turning resource booms into bust, but this time could be different.


From the gold rush of the 1850's, to wool booms in World War I and the Korean War, almost all the good times ended in recession. Yet that was not really because external demand collapsed or prices retreated.

Rather, a surge in the terms of trade — what Australia gets for its exports compared to what it pays for imports — showered the country in cash which was spent with abandon. This red-hot demand sparked an outbreak of inflation which could only be contained by a severe tightening in policy.

In the previous boom in the late 1970's, for instance, annual inflation topped 12 percent while interest rates hit 17 percent. It was this inflationary spiral that ruined the party.

There are crucial differences this time that offer hope that a slump can be avoided, the most important of which is the absence of malign inflation.

Seven years into the current boom, the economy has expanded by 60 percent, yet inflation is under 2 percent, the very floor of the Reserve Bank of Australia's (RBA) target range. Australia has not had a recession in 21 years, it was the only developed nation to avoid one during the global financial crisis, and this year it will overtake Spain as the world's 12th largest economy, despite being 52nd in terms of population.

Instead of needing to tighten the screws, the central bank had room to cut interest rates in May and June taking them to 3.5 percent, and it might well ease again next month.

Some of this good fortune comes from having a freely floating currency, as its strength has pushed down prices for imported goods while keeping a clamp on the non-mining economy.

A more flexible labor market has helped stop wages taking off, and even the global financial crisis played a part by scaring consumers into spending less and saving more.

So, while much of the media has rushed to declare the boom dead and buried, policymakers are not arranging a wake just yet.

"Previous terms of trade booms were periods where we blew ourselves up," Glenn Stevens, the governor of the Reserve Bank of Australia (RBA) told lawmakers last month. "The boom crashed and everything went backwards."

"What is interesting about this boom, is that the overall economy has come through this without a big breakout in inflation, and I think we will come through it without a slump at the end," was his cautiously optimistic assessment.

A Longer-Lived Boom

Part of the disconnect is due to a misperception that the mining boom is somehow a binary being — it's either on or off. In reality, it has several life-stages spread over many years.

First came the surge in the terms of trade, which began in 2005. That fuelled a huge rise in resource investment, which has some years yet to run. Lastly, but often overlooked, comes the expansion of output that is the point of all this investment.

The first of these stages actually peaked almost a year ago, in the third quarter of 2011, when the terms of trade reached heights unseen in over 150 years. Having doubled in a decade, the terms of trade have since fallen by 10 percent, though that remains very high historically.

The second stage of investment really only got going back in 2007 and still has a few more years to run, even with all the talk of miners scaling back.

Projects committed to and underway still amount to around A$270 billion and spending is not expected to peak until 2013 or even 2014. Fortunately, A$180 billion of these projects are in liquefied natural gas, which is nowhere as dependent on Chinese demand as iron ore, with Japan and South Korea both big buyers.

Crucially, most of the LNG due to be produced has already been sold under long-term contracts, some out as far as 2039. which are linked to the international price of crude oil.

"The fact that LNG accounts for the vast majority of Australia's resource investment pipeline naturally means that recent sharp falls in iron ore and coal prices pose no threat to the viability of these projects," says Alvin Pontoh, an Asia-Pacific strategist at TD Securities in Singapore.

That's important as the Bureau of Resources and Energy Economics, the government's official forecaster, predicts LNG export volumes will quintuple by 2020, making the gas as valuable an earner as iron ore is now.

"With the rise of LNG, the economy will change in a fundamental way, as oil prices - indirectly through gas - take a much more central role," says Pontoh.

Patience Has It Rewards

And while some miners are scaling back on their most ambitious expansion plans, this is not necessarily a bad thing. For, what is good for a single miner, might not be best for Australia as a whole.

The aim for the miner is to make the most of high prices by beating his competitors and expanding production as quickly as possible. But when all miners are doing this, it leads to spiraling wage and construction costs.

That adds fuel to domestic inflation while lowering future profit margins, and thus tax receipts. Often, money is spent on projects that were marginal at best and need permanently high commodity prices to stay afloat.

The rush to produce also raises the risk that supply will outpace demand, pressuring prices.

And while the miners have only bought the right to extract and sell, it is the Australian people who own the resources.

From their point of view it might be better if the expansion was more orderly so as to maximize returns over the long term.

It's an obvious point, but these resources can only be taken out of the ground once.

The RBA's Stevens aired his own reservations.

"And there are a vast number of possibles which, I think, in truth, really should not be done," the central bank chief said. "There is already pressure on the cost side for the resource companies doing what they are doing, and you probably just cannot do everything that people have postulated."

Living in a Nominal World

That is not to say everything is going to plan.

Spot prices for the steel-making mineral, and Australia's single biggest export earner, have tumbled by a more than a third since early July to reach a three-year low of $86.70 a tonne.

The speed and scale of the slide came as a rude shock for Australia's miners as they had thought there was a floor in the $110 to $120 range because below that many Chinese iron ore miners become flat out unprofitable.

Since iron ore export earnings were running at over A$60 billion a year, this fall in prices if sustained would imply a hit to trade of at least A$20 billion annually.

All of which is a big blow to national income and is already taking a toll on measures of current price, or nominal, gross domestic product (GDP).

During the height of the terms of trade boom, nominal GDP routinely grew at more than 8 percent annually, a speed usually only enjoyed by youthful emerging nations.

But by the second quarter of this year nominal GDP growth had slowed to just 3.2 percent, leaving it in the highly unusual position of being lower than real GDP of 3.7 percent.

With the terms of trade likely to fall sharply this quarter it is possible nominal GDP could also contract.

During the height of the global financial crisis in 2009 the terms of trade dropped for four straight quarters while current price GDP contracted for two — a sort of nominal recession.

That matters as nominal GDP essentially measures the amount of cash sloshing around the economy, pointing to pressure on profits, dividends, wages and tax receipts.

"A falling terms-of-trade does mean that some of the insulation protecting the economy is fraying," said Michael Blythe, chief economist at Commonwealth Bank.

"But the current boom has run further and longer than any other," he added. ""This time is different" is always a dangerous thing to say, but maybe this time it is."

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