Australia nears the edge of a capital cliff

When Reserve Bank assistant governor Guy Debelle gave a speech last week explaining how the resources investment boom has been funded it appeared an interesting but academic dissertation. Research by Bank of America Merrill Lynch, however, puts that speech into a somewhat disconcerting context.

What Debelle said was that 80 per cent of the investment by Australian-listed resource companies, and more than 90 per cent by foreign companies, had been funded internally and that about 80 per cent of that funding had been sourced offshore.

As he said, that has had a material effect on capital flows. Foreign capital flows into the Australian resource sector had grown from an average of about one per cent of GDP in 2007 to about 3.5 per cent in 2012.

That was partly attributable to the funding of the resource investments but also to a big increase in foreign purchases of Commonwealth government securities, offset to some degree by net repayments of offshore borrowings by the banks as they seek to reduce their exposure to offshore wholesale debt markets.

Debelle’s conclusion was that the net effect of the capital flows was that the Australian dollar was higher than would be expected from the fundamentals like terms of trade and interest rate differentials.

The BoA Merrill Lynch research, released to clients last Friday, looks at the resources investment boom and comes to the tentative conclusion that it could end with a bang in 2015-16.

As the analysts (economists Saul Eslake and Alex Joiner) say, there are currently seven big LNG projects under construction with a total cost of about $194 billion.

Those projects – the three big Queensland coal seam gas-fed facilities, Gorgon, Prelude and Wheatstone in Western Australia and Ichthys in the Northern Territory – are scheduled for completion between 2014 and 2016, with almost 60 per cent of their spending already completed.

While the Bureau of Resources and Energy Economics has identified another $130 billion of projects either at the feasibility stage or announced, the altered environment for resource investment – inflated costs, a high dollar, increased regulation, the potential for US shale gas to find its way into export markets and attempts by Japanese buyers to change the pricing regime from one that is oil-linked to one based on US Henry Hub domestic gas prices – makes it unlikely that investment will eventuate.

BoA Merrill Lynch cites the example of Woodside’s ditching of the proposed $45 billion onshore development of its Browse Basin project earlier this month as evidence that the prospects of those projects not yet under development proceeding are diminishing.

With all but Ichthys due to be completed by 2016 the LNG projects could be the last of the big lumps of resource investment sparked by the now-receding commodities price boom.

If that boom in investment ends abruptly, so should the flows of foreign capital that have largely funded it. That, as the analysts point out, could pull the rug from under the value of the dollar and could be exacerbated if their dwindling coincides with a US Federal Reserve Board unwinding of its quantitative easing program, which would probably see US interest rates rise.

That’s not necessarily a bad thing – the strength of the dollar has been damaging the non-resource sectors of the economy and to some extent, because its input costs and revenues are largely US dollar-driven, the resources sector itself.

Whether the rest of the economy could adjust quickly enough, and start investing strongly enough, to compensate for the end of the resources investment boom is, of course, a significant question.

While the BoA Merrill Lynch analysis acknowledges that even as the investment levels fall off a cliff in 2015-16 the LNG projects will begin generating export revenues of around $20 billion a year – but their employment levels will plummet from around 35,000 during the construction phase to less than 8000 once they are operational.

It raises the possibility that an abrupt end to the resources investment boom could trigger a recession with a limited ability for policymakers to respond given their reduced scope (and will) to embark on major stimulus programs. It also makes the point that a big fall in the value of the dollar might make the Reserve Bank reluctant to cut rates because of the concerns about the inflationary effects.

It is the abruptness of the end of the investment boom that the analysis foreshadows, and the impact this would have on capital flows and the dollar, that makes the BoA Merrill Lynch analysis such a neat fit with Debelle’s speech.

Combined they constitute what is potentially a very sharp jolt to the economy and a significant challenge for policymakers with limited flexibility to respond. If China’s recent economic slowdown were to continue, or worsen, the transition out of the resources boom could be even more difficult and painful.