By Satyajit Das, derivatives expert and the author of Extreme Money: The Masters of the Universe and the Cult of Risk Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)
Your Excellency, I am pleased to present the requested report on the economic outlook for the Great Southern Province of China, currently referred to by the local population as “Australia”. For convenience I will refer to the country by this older name. We will now turn to the outlook.
A Fork in the Economic Road …
The commodity boom has created a “two track” economy – as your Excellency know economists prominent in the media love glib “sound bites”. The mining and commodity boom benefits a small part of the economy whilst simultaneously creating problems for other parts.
The mining and energy sector account for less than 10% of the Australian economy. This is smaller than the Australian finance sector or manufacturing industry.
Mining and mining-related sectors, such as construction, manufacturing and services industries which benefit from mining activity, make up about 20% GDP. These sectors will contribute approximately two-thirds of the projected 4% GDP in 2011/12. The remaining 80% of economy will contribute one-third of growth.
Mining employs 1.5% of the workforce reflecting its capital intensive nature. Unfortunately, a portion of the equipment needed is imported adding to the current account problem, especially in the short run. A combination of high domestic costs and the strong Australian dollar means that a significant portion of project related work is now done offshore.
The revenue earned and the overall contribution to national income does boost the economy and creates employment. But dividends and interest payments to overseas investors reduce the amount of earnings that stays in Australia.
The concentration of mining activity in Western Australia and Queensland also creates imbalances within the domestic economy. Skill shortages in mining means rising salaries, attracting workers from other industries and placing pressure on general wage levels. It also exaggerates property price increases in some areas. This creates inflationary pressure that forces the Reserve Bank of Australia to raise interest rates.
The rising demand for Australia’s mineral exports also pushed up the value of the Australian dollar. Since deregulation in 1983, one Australia dollar has purchased, on average, around 77 US cents. The commodity boom and Australia’s high interest rates relative to the rest of the world increased the value to around 95 to 100 US cents, peaking at around 110 US cents.
The high Australian dollar places exporters at a cost disadvantage and also makes it difficult to compete with cheaper imports. Affected sectors include key Australian export industries that are significant employers such as education services, tourism and manufacturing. Australia may lose up to 170,000 manufacturing jobs over the next 10 years, almost double lost jobs in the past decade.
The domestic economy remains lack lustre. Consumers are affected by significant debt levels and weak wage growth. Public spending has fallen reflecting pressure to return the budget to surplus. Business investment has been weak, reflecting sluggish demand.
Debt levels remain high. Between 1991 and 2011, household debt rose from around 49% to 156% of disposable income. In 1989, when mortgage rates were 17%, the ratio of interest payments to disposable income was 9%. Currently, despite the fact that mortgage rates are around 7.5%, the ratio has increased to around 12%. As households increase savings and reduce debt, consumption is lower contributing to slower growth.
Slow growth in credit, reflecting households reducing debt and problem in the banking sector, also constrains growth. Employment in manufacturing, retail and financial services is weakening, with major employers announcing layoffs.
There are other unresolved problems. Housing prices remain high based on traditional measures such as affordability and rental returns.
According to the latest Economist survey (published on 26 November 2011), Australian house prices were overvalued by 53% based on rents and 38% measured against income levels relative to long run averages. According to The Economist, Australian home prices are overvalued by at least 25% based on the average of these two measures. The level of overvaluation is greater than in America at the peak of its housing bubble.
As your Excellency personally experienced during his visit to Australia, no subject excites greater passion among the locals than house prices. This is a staple of conversation and people excitedly compare the size of their mortgages and the value of their accommodation. There is heated disagreement between those who believe that house prices will not fall and other who forecast substantial price falls.
The real issue is over investment in housing stock, which produces low or nil return. Encouraged by complex subsidies, large amounts of capital are locked up in housing, unavailable for more productive wealth creating activities such as new industries.
In international rankings, Australia regularly performs poorly in competitiveness, productivity and innovation. This is inconsistent with the national character, which prides over achievement in competitive sports. Australia believes it can “punch above its weight”.
In a recent paper entitled “Productivity – The Lost Decade”, economist Saul Eslake found that Australia’s productivity growth during the 2000s was 0.50% below that of the 1990s, when it was broadly comparable to the OECD average. Between the mid 1990s and the mid 2000s, annual labour productivity declined from 2.8% to 0.9% per annum. Over a similar periods, broader measures of productivity that incorporate capital as well as labour fell from 1.6% to near zero.
The GE Global Innovation Barometer ranked Australia 16th out of 30 countries, well behind the leaders like the US and Japan. While 18% of local business leader, perhaps blinded by patriotism, nominated Australia, only 2% of global senior business executives citing the country as an innovation champion.
The GFC also significantly reduced the wealth of individuals, especially retirees. The value of their investments declined. At the same time, income and returns from investments also declined. The “wealth effect” limits consumption but also encourages those planning for retirement to increase their savings.
These problems mean that Australia’s non-mining sector is forecast to grow at a modest 1% per annum, compared to the mining sector which is forecast to grow at 5%.
Where are We Now…
Your excellency, the country is a fest of complacency. Locals are convinced that there is no end in sight for the mining boom driven by China’s growth. They believe that they are protected against the problems in Europe and elsewhere. Anyone who points out the risks is dismissed as a pessimist and doomsayer.
Despite the recovery, many parts of the economy, other than the buoyant mining sector, remain subdued. The stock market, although not an accurate measure of economic health, remains over 30% below its levels before the crisis. Interest rates for 3 and 10 year government bonds have fallen sharply to record lows, reflecting increased pessimism amongst investors about economic prospects.
Australia remains vulnerable. A slowdown in Chinese growth and fall in commodity prices and volumes would affect the economy adversely. Australian history suggests that mining booms are finite and end suddenly causing significant disruption.
Problems in sovereign debt and attendant pressures on banking system may decrease available funding and increase borrowing costs for Australian banks and companies. Overvalued house prices and high household debt increases vulnerability to an economic slowdown, with an accompanying rise in unemployment or to higher mortgage rates. A credit crunch or recession could cause house prices to fall worsening domestic conditions, which would in turn affect domestic banks.
The perfect storm for Australia would be the coincidence of those events.
Australia has some flexibility. Public debt around A$250 billion is a modest 22% of GDP providing flexibility to stimulate the economic. But this capacity can be over estimated. Prior to the GFC, Ireland’s debt levels were modest around 25% of GDP but the need to bailout troubled banks and the collapse of the real estate market led to debt levels increasing rapidly.
Australian interest rates are relatively high (official rates are 4.25%), providing flexibility to cut borrowing costs to buffer any shock. The currency is flexible and a fall in value of the Australian dollar would help cushion any weakness, as was the case in 1997/1998 Asian crisis and again in the GFC.
Your Excellency will also be aware that Australia Treasurer Wayne Swan was recently anointed as the world’s best Finance Minister. His skills may assist in navigating through any crisis, should such an event occur. But it is worth noting that a previous Australian Treasurer received similar accolades in 1984, only to subsequently preside over a deep recession, which “the country had to have”.
Your Excellency has requested my recommendations for whether we should launch our bid for Australia, to be renamed the “Great Southern Province of China”. I believe that we should await developments. We should be able to acquire Australia at a cheaper price in the not too distant future.
The Chinese Envoy