The term "Dutch disease” refers to the hollowing out of an economy’s manufacturing sector (and other non-mining-related sectors) following an increase in mining investment and income and a related increase in the value of the currency. The term derives from the decline in the Netherlands’ manufacturing sector in the 1960s after the discovery of a major natural gas field.
Not only does the mining investment redirect labour and capital resources away from other sectors, but the export-driven currency strength also hinders demand within the non-mining sectors. That said, the diagnosis of full-blown Dutch disease also requires the higher demand for commodities and investment in mining to be temporary.
In the Australian economy, the investment pipeline and long-term demand for the country’s abundant natural resources are both robust; however, offshore demand likely will not continue to grow in a straight line, and the global supply response is already forthcoming. For example, with the current price of iron ore still well above PIMCO’s estimate of the reinvestment price, we expect producers in Australia, Brazil and Africa to ramp up new iron ore projects by 2014, which in conjunction with declining steel demand from China will likely result in downward pressure on the iron ore price.
While Australia is very well positioned as a low-cost producer of iron ore and will also likely benefit over the coming years from dramatically increased liquefied natural gas exports, we think these circumstances are already fully priced, especially in terms of the Australian dollar, although this is gradually starting to correct.
Close ties to China’s growth
Over the past decade, China has become Australia’s largest trading partner, and has been a significant contributor to the demand for Australia’s commodities. China’s historical focus on infrastructure building has amplified the divergence in Australia’s two-speed economy, in which the natural resources sectors significantly outpace the consumer and manufacturing sectors.
Going forward, PIMCO expects China’s policy response to be much more reactive to economic weakness, rather than proactive, given domestic banking stresses and the political timetable. PIMCO’s cyclical forecast for 7-8 per cent growth in China is close to the forecast by Chinese policymakers, yet remains well below market consensus estimates, some of which have increased in recent weeks.
China’s investment-driven growth model has propelled the nation’s steel demand to unsustainable levels – the property sector alone has accounted for approximately 30 per cent of steel demand. PIMCO estimates Chinese steel production in 2012 will fall approximately 2 per cent, having grown on average by over 10 per cent for the past three years, which reflected the heavy emphasis on infrastructure as a key component of the 2008–2009 stimulus packages.
This decrease in Chinese production, accompanied by near-record-high steel inventory levels, will likely continue to pressure iron ore prices – which in turn will flow directly through to Australia’s terms of trade, which has already been declining since the fourth quarter of 2011 (see figure 1).
Employment, housing, consumers under moderate pressure – and growth may disappoint
Australia’s two-speed economy is quickly becoming very unbalanced. Many non-mining sectors are no longer globally competitive – manufacturing, for example, has seen a significant drop as a share of the Australian workforce (see figure 2) – but these non-mining sectors are much more influential on employment prospects.
Unemployment has remained low at 5.2 per cent, which has thus far protected the non-mining sectors of the economy, yet the signs of stress are becoming more apparent. Despite the strong contribution of the mining sector to Australia’s enviable long-term growth rates, the mining sector employs less than 2 per cent of the workforce (see figure 3).
In turn, employment outcomes will likely drive the property market, which we believe will remain under pressure through 2012 and beyond. And consumers are retreating, as evidenced by higher household savings rates and lower demand for credit.
Given this backdrop, accompanied by significant fiscal drag as we move from budget deficit into surplus, we believe Australia’s growth rate will disappoint going forward. PIMCO’s cyclical forecast for Australian growth is 2.75 per cent to 3.25 per cent. This also implies a weaker Australian dollar, a more substantial monetary policy response, or both.
A milder strain of Dutch disease
This combination of factors leads us to conclude that the Australian economy is suffering from a milder strain of Dutch disease, "Dutch Disease Lite,” rather than a full-blown affliction. Two key factors – or chronic symptoms, we could say – support this diagnosis:
1. The commodity demand boom is likely to continue over the longer term. It is driven by the industrialisation of the region, rather than the kinds of temporary factors that drove previous terms-of-trade booms, such as wool prices during the Korean War.
2. The sectors most susceptible to Dutch disease are price-sensitive commodity-linked export industries, such as manufacturing and agriculture. In Australia these sectors have been in structural decline for decades, and while there have been no signs yet of an acceleration of this process, they are a smaller part of the economy now then they have ever been.
So we are likely suffering from a lighter version of Dutch disease, but we are probably more likely to feel the effects of an extended structural change in the economy as resources continue to be reallocated, rather than the effects of a full-fledged, but transitory, case of Dutch disease. The declining sectors of the economy will continue to do so to make room for a mining sector that is likely to remain larger (if still a relatively small component of the workforce) for an extended period of time.
Fortunately, the policy responses available to Australia due to our clean sovereign balance sheet and monetary policy firepower may also prove effective in combatting the symptoms. Of course, with the elevated level of uncertainty regarding the outlook, execution risks and the chance of policy error may be higher than normal.
From an investment perspective, we believe Australia’s strong initial conditions should help ensure that Commonwealth government bonds remain one of the world’s "cleanest dirty shirts” for risk-averse investors, especially as the federal budget moves back into surplus and issuance levels reduce. This tightening fiscal position will likely result in interest rates staying lower for longer, the Australian dollar weakening from current levels and continued margin erosion for corporations operating in globally exposed non-mining sectors.
Robert Mead is a managing director in PIMCO's Sydney office and head of Australian and Asia-Pacific credit portfolio management.
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