Starting in 2005 a resource boom in Australia has propelled their economy onwards and upwards. All good things come to an end, and I believe that Australia is in for a hard landing. The combination of a shock to commodity prices, piercing of a housing bubble and extremely poor productivity growth since 2005 could lead to a serious drop in Australian GDP when the day of reckoning arrives.
McKinsey Global Institute have produced an essential study that breaks down what has caused Australia’s growth spurt since 2005, and how the causes of growth have differed from previous growth spurts in the early 1990’s and early 2000’s. It’s called “Beyond the boom: Australia’s productivity imperative“.
Their analysis looks at five different contributors to growth:
Terms of trade: The effect of changing prices for imports and exports
The increase in terms of trade has been fuelled by massive increases in commodity prices. The Reserve Bank of Australia governor is quoted in the report that while one container of iron ore was worth 2,200 flatscreen TVs in 2005 it’s now worth over 22,000 flatscreen TVs. The Australian dollar is at very high levels and is currently at 1.03 USD/AUD – above parity!
Additional capital: The increase in capital stock
The increase in capital stock in Australia since 2005 is astonishing – some A$120 billion in additional capital investment has been made in iron ore and coal mines, roads, ports, natural gas exploration and other resource industry projects. That alone is responsible for 53% of the growth since 2005, meaning any reduction in capital investment would significantly reduce Australian economic growth.
Additional labour: The increase in the total number of hours worked in the economy
Since 1993 Australia has averaged 143,000 immigrants per year and its own growing population has led to a massive increase in the size of the workforce. Massive Kiwi immigration has thus played a key role in accelerating Australian growth. MGI state that the increase in labour is the steadiest contributor to Australia’s growth.
What does this mean if lots and lots of Kiwis return to New Zealand? Well, the Australian economy recovery could potentially be lower than if they stayed there. The same obviously applies to other sources of Australian immigration – Southeast Asia, UK, Ireland, South Africa. Birth rates in Australia seem to be propped up by the baby bonus they have there. If fiscal necessity means that has to be cut the rise in natural born population will decrease sharply and affect this contributor to growth by the 2020s/2030s.
Capital productivity: The amount of output generated per unit of capital stock
Between 2005 and 2011 capital productivity has plummeted and led to tens of billions of dollars in losses of national income. MGI argue that this is because of the massive time lags between planning a resource project and getting the first shipment despatched, which can feasibly take years because of the size of the projects.
This finding is amazing – all of this capital investment, yet the losing capital investments are essentially cancelling out many of the one-off gains from a resource boom. This does not bode well if commodity prices decline, because that would reduce the value of resource projects already committed to and underway even further.
Despite hundreds of billions in domestic wealth, hundreds of billions more is being borrowed from overseas to finance these capital investments. If Australia’s exchange rate plummets in the wake of reduced commodity prices the repayments on bonds issued in USD, EUR, JPY, RMB or even SGD will skyrocket and reinforce a downward spiral of investment.
Labour productivity: The amount of output generated per hour worked
Despite having 25% more capital at their disposal from 2005 to 2011, output only increased 7%. Over the past 6 years labour productivity increases have only contributed a roughly a third as much as they did between 1993 and 1999. (A$17 billion vs A$57 billion). Other sectors in Australia have been achieving lacklustre labour productivity growth of ~1% a year.
All in all, MGI conclude that at least 50% of the growth from 2005 to today is one-off effects of the mining boom. The reality is that Australian multifactor productivity is actually declining at 0.7% a year. McKinsey talk about four different scenarios for Australia, linked directly to how much they increase productivity. They call these scenarios “hangover”, “lucky escape”, “earned rewards” and “paradise”.
This is how they arrived at their numbers:
Using the methodology that MGI used to calculate these 4 scenarios, what happens if we make the assumptions slightly more negative? If the “hangover” situation occurs, there is not much breathing room until the total change of total income becomes negative.
In the “hangover” situation, if the relationship between additional capital and capital productivity (-43/120) holds the negative contribution of capital productivity would surely be (-43/120)*107= -$38.34 billion. That would change the “hangover” calculation to : -109+107+28-38+8= -$4 billion.
Any further deterioration in Australia’s terms of trade would make the reduction in total income even higher. Any decrease in additional capital would make the reduction in total income even higher. This report reinforces my bearish opinion of Australia – they’re squandering their resource boom resources and not focusing aggressively enough on improving multi-factor productivity.
And let’s not forget where a lot of this capital investment is coming from:
When Australia’s terms of trade decline, any foreign-denominated borrowings will be more expensive to repay. This could prove fatal to any recovery because a substantial proportion of national income will be spent on debt service instead of capital investment, further reinforcing the hard landing provided by a decline in commodity prices.
Australia is in for a hard landing because they’ve squandered their natural resource dividend on a housing boom and holiday homes in Bali. Their failure to address productivity issues in the resource sector and other sectors will make the inevitable recession far more painful than it could have been if a more responsible approach to shoring up the long-term prospects of Australia had been taken.