Dog Days: Australia After the Boom (Redback)

by Garnaut, Ross

  CHAPTER 4: THE HAIR OF THE DOG

  Australians now have to live with the hangover from the biggest housing, spending and resources booms in our boom-and-bust cluttered history. So far our response has been to take another drink, with no end in sight during the 2013 election campaign. Our spending and our real exchange rate have risen to levels far beyond what is sustainable. The challenge now is to manage their falls in ways that do the least damage to employment, our living standards and the quality of our society.

  THE RESOURCES BOOM: THREE PHASES

  As discussed in the Introduction, it is useful to think of three overlapping phases of the resources boom: the terms of trade phase, the investment phase and the export expansion phase. The terms of trade phase began in 2002 and affected the Australian economy from 2003. Apart from a break in the year following the Great Crash of 2008, our terms of trade rose rapidly and consistently to a peak in September 2011. The downward slide since then has been as rapid as the rise, and more likely than not in 2014 or 2015 we will see much lower levels still.

  The investment phase got underway in 2006, but increased gradually until 2010 and also with a break after the Crash. Resources investment as a share of the economy looks set to reach a peak late in 2013. It will then decline until it is not far above the historical average in about 2017. The effect of this investment on the Australian economy in any year is a mixture of the positive, from the capital expenditure, and the negative, from the corporate tax deductions it allows. The net positive effect of resources investment was probably greatest in 2012 and will become a net negative for a number of years after 2017.

  The third phase, the expansion in export volumes, began in 2012 and will continue for a year or so after the end of the investment phase, to about 2017.

  If we put these three overlapping phases together, and since we spent most of the increased income from higher export prices as it arrived, we can see the expansionary effect of China’s demand on the Australian economy commencing in 2003 and growing steadily stronger (with the break after the Great Crash) until 2011. The positive impact of the China resources boom on the overall Australian economy ended in late 2011. Since then, the overall impact of the resources sector has been contractive and is likely to remain so for a number of years.

  The three phases contribute to the Australian economy in different ways. It is worth looking at each of them in more detail, so as to understand the underlying forces driving big changes in our economy.

  THE BIGGEST PHASE: TERMS OF TRADE

  Strong terms of trade contribute mainly to government revenue, but they also raise the income of Australians who own shares in resource companies. At their peak in September 2011, the terms of trade were more than double the average of the first twenty years of the floating currency (1983–2002). This added almost 24 per cent to nominal gross domestic product.

  Yet much of this increase did not directly affect the Australian economy because about three-quarters of the equity in resource companies is owned overseas. The main effect of the higher terms of trade was to raise potential government revenue by around 10–11 per cent of GDP, with about 1 percentage point accruing to the states as royalties and the rest to the commonwealth as corporate income tax, capital gains tax, resource rent tax on offshore petroleum, income tax and withholding taxes on dividends from resource companies. (I say potential, because if the increased revenue is spent, as it was, it raises the cost level of the economy and the real exchange rate, which in turn reduces resource-sector profits and government revenue.)

  Separately, the terms of trade raised potential Australian incomes by about 2.5–3 per cent of GDP through increased dividends or increases in the retained earnings of companies whose shares were held by Australians directly or within superannuation funds. There was an additional wealth effect as the price of resource company shares rose in anticipation of higher future earnings. So the total effect of the terms of trade boom from the average of 1983–2002 to the peak in late 2011 was to raise potential average incomes of Australians by more than one-eighth.

  Since late 2011 there has been a steady decline in the resources sector’s contribution to Australian incomes. How low will the terms of trade go and for how long? That depends on conditions specific to each industry.

  For iron ore, immense investments in supply capacity in Australia and other countries are causing a huge increase in volumes to come to market at a time when the growth in Chinese demand has slowed sharply. This has brought down prices and will take them further as supplies increase considerably from late 2013. Similar dynamics are influencing metallurgical coal.

  The extent of the reduction in Chinese production as prices fall will be an important determinant of future prices. There are prospects for average future iron ore and metallurgical coal prices to settle higher than in the late twentieth century, and lower-quality mines will come into production to meet absolutely higher levels of demand. But these prices may be only half the peaks of late 2011 in real terms. There could be early periods when China is undergoing structural change and global supply is increasing rapidly in which prices are temporarily lower than future averages.

  Thermal coal use may not grow much, if at all, from late 2011 in China, the world’s largest market, so that increasing global supplies may cause real prices to settle at much less than half the 2011 peaks. Again, much depends on what happens to production from mines in China.

  Liquefied natural gas (LNG) exports will become increasingly important, so that gas prices will be influential in determining our terms of trade. Australian gas goes mainly to East Asia, where prices have been determined by formulae linked to oil and are now well above North American levels. Environmental priorities will cause Asian demand for gas to grow more strongly than for Australia’s other commodity exports. At the same time, world capacity is growing rapidly, with big investments in exploration and production applying old as well as unconventional technologies. Large efforts to expand domestic gas supplies in China (not yet certain to have broad success), overland pipelines from central Asia and Russia, new supply capacity in Canada and Mexico (as ways are found to subvert US controls on gas exports), the relaxation of export restrictions from the United States and a huge expansion of seaborne export capacity in Australia, Papua New Guinea, Southeast Asia and the Middle East are all increasing supplies to East Asia. The overall effects of these changes are not clear, but it would be surprising if Australian export prices didn’t settle well below current levels in real terms.

  Prices for tourism, education and other services are set in Australian dollars, so they rose for overseas customers as the real exchange rate went up, and will fall as the dollar comes down. This will place a significant drag on the terms of trade. Agricultural prices will generally be moderately higher than in the late twentieth century, reflecting Asian demand and constraints on global supplies.

  My best guess is that the terms of trade will settle on average about a quarter higher than the 1983–2002 average, which is a bit more than one-quarter lower than mid-2013. Potential government revenue from resources would be about 7 per cent of GDP below the peak of 2011 (or about 4 per cent below mid-2013 levels). Other potential Australian incomes from ownership of shares in mining companies would contract by 2 per cent of GDP from the peak (or 1 per cent from mid-2013). This means that the ‘permanent’ contribution of the 21st-century lift in the terms of trade to Australians’ average incomes is likely to amount to about 3 per cent of GDP, or about 10 percentage points lower than at the peak of the boom.

  The increase in revenues from the boom could have been saved by government. If all of it had been saved, pending clarification of how much of the increase was going to be permanent, the main effect of the terms of trade boom would have been to support budget surpluses, mainly in the commonwealth but also in state governments.

  As it turned out, almost all of the revenue increase was used for tax cuts or increased
spending soon after it arrived. The resulting public and private spending increased the demand for Australian labour and supplies. The economy was already in full employment, so this in turn raised domestic costs and the real exchange rate. That forced the decline of other trade-exposed industries, which freed up the labour that had been employed in these industries. Every announcement of a new mine meant an unannounced closure or failure of a hotel or university department or winery or factory. This process continued until enough investment and production had been shrunk or closed to meet the demands that the higher expenditure was making.

  The higher real exchange rate reduced the profitability of resources production (as well as of all other trade-exposed industries). It therefore took away part of the increase in government revenue. But this economic value did not just disappear – the real purchasing power of Australian incomes rose with cheaper imports, and Australian consumption increased to unprecedented levels.

  Even with the higher exchange rate taking the edge off government revenues, the increase was remarkable. Corporate income tax receipts alone rose from $27 billion in 2002–03 to $65 billion in 2008–09. That was the high point in real terms: the revised budget numbers released in August 2013 showed that only $69 billion was expected in corporate tax revenue for 2013–14, which is one-eighth lower per Australian in real terms than five years before, in the midst of the global financial crisis.

  THE INVESTMENT PHASE

  The second phase of the resources boom saw capital expenditure on resources projects rise from historical averages of less than 2 per cent of GDP to more than 8 per cent in 2013. This investment contained a high proportion of imported goods and services, which reduced its impact on the Australian economy by perhaps a percentage point of GDP compared with the same amount of investment in other industries.

  The big rise in investment began in 2006, stalled for a year or so after the Great Crash, and reached a peak in 2013. The larger part of the increase in resources investment came after the Great Crash.

  Before the Great Crash, much of the increase was funded (directly or indirectly) by capital inflow. After the Crash, more was funded (mostly indirectly) from higher national savings. During this period, household savings increased, partly in response to the uncertainty and anxiety induced by the financial crisis and its long international shadow. Lower consumption reduced the demand for Australian labour, thereby freeing about half of what was required for the growth in mining investment from the Great Crash up to 2013. But the balance of the increase in investment – amounting to about 2 per cent of GDP – increased labour and other costs and therefore further pushed up the real exchange rate.

  The investment phase of the boom has affected the economy independently of government decisions on taxation and expenditure. It immediately and automatically increased demand for Australian labour and supplies. This has augmented the effects of spending the income from higher export prices in pushing up local costs as mining outbid other industries.

  The higher exchange rate made all of our trade-exposed industries less competitive – in the resources sector as well as in services, manufacturing and agriculture. So some of the investment choked off by the higher exchange rate was in resource projects that did not go ahead. Indeed, the bidding up of executive pay, labour costs and conditions, and land and materials prices in the frenzy of the boom meant that the resources sector experienced even greater cost increases in international dollars than other industries.

  Once capital expenditures have been made, investors are able to claim tax deductions for depreciation and amortisation and financing costs. The increased deductions are available over a number of years, eventually accumulating to a ‘loss’ of revenue equal to about one-third of the increase in resources investment. So if the resources boom added an average of about 5 per cent of GDP to investment for eight years, it would lead to a reduction of commonwealth revenue of around 1–2 per cent of GDP per annum spread over perhaps ten years, but later.

  These corporate tax deductions are available whether or not the investment is commercially successful. At the height of the boom, many investments were made that turned out to be commercially unsuccessful and were written off as worthless or written down in the accounts of the companies that made them. Some did not even lead to additional production. That happens in the ebullience of a boom.

  THE EXPORT PHASE

  The third phase of the resources boom – the lift in export volumes – began in earnest in 2012, almost a decade after the terms of trade began to rise. Exports in 2012 increased by 9 per cent for thermal coal, 18 per cent for metallurgical coal and 12 per cent for iron ore: the three main commodities contributing to the boom so far.

  How much more will these exports grow? The Bureau of Resource Economics and Energy’s September 2013 projections have been adjusted downwards from those presented at the height of the boom. They now anticipate growth in thermal coal exports of 43 per cent in the five years from 2012–13, and of 43 per cent for metallurgical coal and 59 per cent for iron ore. Even these lower projections of Australian exports (combined with large increases in other countries) would push prices down considerably now that China’s import growth has eased.

  Some established or new mines will be forced by the market to operate at well below design capacity. How much of the pull-back will be in Australia? That depends on competitiveness, which is weak with the exchange rate of mid-2013 and after the big exchange-rate falls in other resource-exporting countries, but a large real depreciation would change the story. The Bureau of Resources’ estimates for Australian exports are now built on expectations of a further fall in the dollar to 86 US cents.

  The Bureau’s export projections for LNG show the largest increase: nearly 300 per cent, mostly between 2015 and 2018. This is possible given the Chinese government’s encouragement of gas for environmental reasons, as well as the setback to nuclear energy in Japan caused by the Fukushima disaster.

  These official forecasts are within the realm of the possible, after several years of being unrealistically high. There are still risks on the downside, especially if there is no large depreciation. The possibilities of surprise on the upside depend on a large real depreciation. Taking into account that iron ore, coal and LNG are not the whole of resources exports, and that resources are not the whole of exports, with the real exchange rate remaining at its mid-2013 level it is possible to envisage total export volumes rising by about 6 per cent per annum in the export expansion phase of the resources boom, between 2012–13 and 2017–18, with resources contributing almost the whole of the increase.

  Only a modest proportion of this increase in resource export volumes contributes to the Australian economy. State government revenues grow relatively strongly, because their royalties depend on the value and not the profitability of exports. Higher volumes and moderately higher prices together will cause state revenues from resources to be larger by over 1 per cent of Australian GDP than before the boom. This revenue goes first to the export states, especially Western Australia and Queensland, but then is ‘equalised’ across the states and territories by our unique system of revenue distribution.

  The commonwealth’s revenue depends on profitability, and the new exports have much higher costs than the old. The commonwealth may receive less revenue from the increased export volumes than it loses from falls in price and increases in investment-related tax deductions until the early 2020s.

  AVERAGE EMPLOYMENT IS ALREADY DECLINING

  Spending the temporary bounty of the resources boom has caused the exchange rate to rise exceptionally. At its peak in early 2013, the real exchange rate was almost 70 per cent above the 1983–2003 average. The extent of the increase is unique in our history. Even after the substantial falls in the dollar in the second quarter of 2013, the real exchange rate was still one-half above that long-term average.

  Such a lift caused other industries producing exports or competing a
gainst imports to contract. This is the phenomenon known as the ‘Dutch Disease’ or ‘Gregory Effect’. The rapid increase in net exports in these industries as a share of the economy from the mid-1980s went into reverse, and by 2013 we were pretty well back where we had been before the Reform Era. Similarly, there was a switch from buying goods made in Australia to buying competing imports, and from producing goods and services for export to producing them for the home market.

  If there is no adjustment of the real exchange rate and no budget stimulus (as discussed in Chapter 5), we can expect a smaller resources sector contribution to the economy in late 2017 than in 2013, which itself is lower than in 2011. The immediate impacts will lead to reductions in demand for other domestic goods and services, thereby magnifying the decline.

  There has been a noticeable deceleration in the Australian economy since late 2011. Economic output has increased at less than long-term average rates and consistently below official estimates. Much of the decline has been felt as a fall in government revenue – with both commonwealth and state revenues consistently and steadily falling below estimates every six months since the second half of 2011. The main locus of the iron ore boom, the state of Western Australia, had its credit rating downgraded in September 2013. National employment grew less rapidly than the adult population, with monthly hours worked per adult falling from 89.1 to 86.8 between the peak in October 2011 and August 2013. Growth in real household income per adult has fallen from an average rate of around 2.5 per cent per annum in the decade to mid-2011 (a period without any productivity growth) to a third of that since then.

  Australians continue to expect higher incomes, more services and lower taxes, but our economy’s capacity to deliver these things to the average Australian is declining. In other words, Australia has been in the Dog Days since late 2011. Successive prime ministers and treasurers have been correct in saying that our economic conditions are among the best in the world. Yet Australian expectations of ever-increasing standards of living are now being disappointed.