DRAGON’S TAIL
Correspondence
Andrew Charlton’s Dragon’s Tail raises a number of important issues about Australia’s prospects. “Australian exceptionalism” has been underpinned by the nation’s economic performance, which has been superior to that of most developed nations, especially since the economic crisis of 2007 to 2008. There are several reasons to doubt that the nation’s enviable performance can continue. It is not clear that policy-makers and citizens have an adequate understanding of the issues and are willing to make the difficult choices necessary.
First, Australia’s enviable strong consistent economic growth, low unemployment and increasing living standards were driven by demand for commodities from emerging Asian nations, especially China. With the Middle Kingdom now accounting, directly or indirectly, for around 40 to 50 per cent of Australian exports, Australia has become the “great Southern province of China.”
But Chinese growth is slowing and is structurally unsustainable, being driven by excessive reliance on debt-fuelled investment. Even if growth levels remain above those in developed markets, the changing composition of growth (a rebalancing from investment to consumption) means that resource-use intensity will decrease, reducing demand for commodities. Increased capacity, as a result of aggressive recent investment, will also come on-stream, coinciding with lower demand to put pressure on prices and volumes.
The sustainability of Australia’s mineral wealth is overstated. Australia has demonstrated economic reserves of iron ore that at current production rates will last around seventy years. The comparable figures for coal and liquefied natural gas are around 100 and sixty years. But as low-cost reserves, such as the Pilbara iron ore reserves and Bowen Basin coal resources, are depleted, Australia’s resource competiveness will decrease. This will be compounded by the country’s high cost structures and its poor record of cost escalation, which will encourage investors to look elsewhere. Exports of some commodities, such as coal, may be adversely affected by measures to reduce carbon emissions.
A second reason for concern is that the commodity boom, Australia’s role as an investment proxy for China, its AAA-rated safe-haven status and relatively higher interest rates have increased the value of the Australian dollar, reducing the nation’s competitiveness in manufacturing, retail, tourism and exports of education and health services, which are all major employers.
Third, since 2001 Australia’s trade account has been weak, despite the mining boom and record terms of trade. The nation’s external finances remain weak, with a persistent current account deficit of around 3 per cent of gross domestic product, increasing the reliance on international financing.
Fourth, public finances, both national and state, are deteriorating, as strong growth in the commodity sector no longer offsets weak domestic conditions. Government revenues have deteriorated, with significant budget deficits likely.
Public finances will remain weak because of lacklustre economic activity, lack of strong employment growth, low wage increases and migration of corporate profits offshore. Longer-term structural effects such as an ageing population are major factors.
In a speech entitled “The End of the Age of Entitlement” to the Institute of Economic Affairs in London on 17 April 2012, Shadow Treasurer Joe Hockey questioned the economic sustainability of “entitlements bestowed on tens of millions of people by successive governments, fuelled by short-term electoral cycles and the politics of outbidding your opponents.” It was reminiscent of an observation by former Australian Treasurer and Prime Minister Paul Keating that you cannot “get quarts from pint pots.”
Hockey argued that “government spending on a range of social programs including education, health, housing, subsidised transport, social safety nets and retirement benefits [had] reached extraordinary levels as a percentage of GDP.” This spending, he stated, should be funded from revenue rather than by borrowing.
In the May 2014 budget, the Coalition government sought to address the budgetary problems primarily by cutting spending. Given the political difficulties and social consequences of wholesale changes in key areas of expenditure, such as health, aged care and education, it is difficult to see how spending cuts alone can achieve the desired result. Popular resistance to cancellation of even poorly targeted welfare measures was noteworthy.
Increases in revenue are needed. This will require changes to tax bases, including increases in the goods and services tax, and adjustment of tax scales, as well as the removal of overgenerous incentives for corporate investment, retirement savings, negative gearing of real estate and taxation exemptions for residences. However, these measures are politically challenging, eliciting a high level of bipartisan caution.
Amusingly, the new government, like its predecessors on both sides of the political divide, will seek to improve its finances from efficiency dividends derived from streamlining the public sector. Given that over twenty years successive governments have taken similar initiatives, it is truly astonishing that more efficiency and cost benefits can be achieved.
Fifth, while Australia’s public sector debt is manageable by global standards, household borrowing and foreign debt remains high and is likely to become an increasing constraint.
Australian household debt at the end of 2013 was around $1.8 trillion, equivalent to $80,000 per person. It has increased to around 180 per cent of household disposable income, a sharp increase from around 60 per cent in 1988 and 100 per cent in 1999. Australia’s net foreign debt is around 54 per cent of GDP. Major international debt-rating agencies have repeatedly raised concerns about the nation’s external liabilities, which make Australia sensitive to external financing shocks.
Sixth, the Australian banking system, while well capitalised, has a very high level of exposure to the domestic economy and the housing market, which is overvalued by most measures. A fall in real estate prices, increases in unemployment and decreases in income could expose financial system vulnerabilities.
Seventh, Australia’s cost structure is high, exacerbated by the high currency. Australian minimum wages are around A$16 per hour, compared to around A$7–8 per hour in the US and A$1–2 per hour in China. The cost of Australian engineers is around A$170 per hour, compared to A$132 in the US, A$129 in the UK and A$77 in Japan. Cash costs in the mining sector have increased by over 250 per cent in the last ten years.
Improvements in productivity have been lacklustre. According to the Global Competitiveness Report 2013–14 published by World Economic Forum, Australia has fallen to twenty-first place, dropping out of the top twenty for the first time. Arch-rival New Zealand is now ranked eighteenth in the world for competitiveness, three places above Australia.
The reality is that major structural reforms that started under prime ministers Bob Hawke and Paul Keating petered out sometime under Prime Minister John Howard.
Eighth, policy attempts to rebalance the economy have had only limited success. Australia’s central bank, the Reserve Bank of Australia, has lowered interest rates to 2.5 per cent per annum, seeking to boost housing and consumption.
To date, lower rates have had a limited impact on housing, credit growth, consumption, non-commodity investment, employment and confidence. Despite recent falls, the ability to unilaterally devalue the Australian dollar remains limited. With the United States, the Eurozone, Japan, the United Kingdom and China pursuing policies designed to weaken their currencies to increase the competitiveness of their exports and reduce the purchasing power of their debts, the Australian dollar may well remain high for a long time.
A lower currency is seen by many as a solution. It may boost exports, but is dependent on external demand, which may be affected by a weak global economy. Currency weakness is a disguised attempt by policy-makers to reduce cost structures within the economy. It seeks to avoid dealing directly with labour costs, productivity and other structural problems. But its efficacy is doubtful.
As Australia is an importer of manufactured products, a lower currency will also increase prices, lowering purchasing power and damping consumption. Higher petrol prices, import costs and transportation expenses will increase a wide variety of costs, offsetting improvements in competitiveness.
Ninth, Australia’s attempt to rebalance towards Asia is flawed. As the commodity and mining boom slows, Australia wants to sell food, education, health care and financial services, as well as attract Asian tourists. But Asia faces its own challenges. Australia’s Asian strategy also suffers from inherent contradiction between Australia’s political and defence partnership with the United States and its economic dependence on Asia. Deep-seated cultural barriers, such as the White Australia policy, which ended only in the 1970s, are ignored. Recent differences over illegal immigration highlight the problems with an Australian “pivot” towards Asia.
In the face of these factors, Australia’s long-term policy options are increasingly constrained. As Australia has a largely open trading economy, policy-makers have a limited ability to influence the nation’s economic future. Australia risks becoming trapped in a cycle of alternating commodity booms and domestic upswings. The latter relies on low interest rates driving real estate bubbles and “shop-till-you-drop,” debt-fuelled consumption by already over-indebted households.
Efforts to wean Australia off its dependence on primary production, mineral and agriculture have had limited success. Catchy slogans such as “the clever country” and “the knowledge economy” have not reshaped the economy.
Attempts to transform Sydney into a major financial centre for Asia have been defeated by the tyranny of distance and Asian nationalism. Tourism, exports of educational, health and other services as well as intellectual property have been more successful. But a high Australian dollar and increasingly high costs threaten these industries. The decline in manufacturing and a general hollowing out of the economy also restricts future options.
The reality of recent Australian history is that the mining boom helped maintain incomes and purchasing power as the nation extracted large rewards for its mineral resources, covering up a lack of international competitiveness in many sectors, driven by high costs, poor productivity performance, declining educational achievements and a narrow industrial base.
On 29 November 2010, in a speech entitled “The Challenge of Prosperity,” the governor of the Reserve Bank, Glenn Stevens, sought to illustrate the combined effect of the gains of the appreciating terms of trade position and the strength of the Australian dollar in the following way: “[In 2005] a shipload of iron ore was worth about the same as about 2,200 flat-screen television sets. [In 2010] it is worth around 22,000 flat-screen TV sets.” In a Freudian slip, the governor had identified the fundamental issue with Australia’s economic model.
Australia may have substantially wasted the proceeds of its mineral boom, with the proceeds channelled into consumption. In November 2012, the former treasury secretary and author of the government’s Asian Century white paper, Ken Henry, mused on the intergenerational effects of Australia’s economic strategy: “future generations … will have reason to examine whether we made the most of the mining boom that we knew would not last forever.”
During an interview on 19 December 2012, Glenn Stevens was asked where growth would come from to replace mining investment. He responded: “I think we always get this question: ‘Where will the growth come from?’ And most of the time it comes.”
In a fragile and challenging international environment, the Abbott government will need to make the right policy choices and have more than the usual quota of luck to maintain the nation’s stellar economic run. It is unlikely that a belief in good fortune – exemplified by Mr Micawber’s confident belief that something is sure to turn up – will suffice.
Satyajit Das