Deloitte Access Economics partner and economist Chris Richardson tells Business Spectator's Robert Gottliebsen and Stephen Bartholomeusz:
The peak of the mining investment cycle is likely in 2014.
Stephen Bartholomeusz: Chris, were you surprised by the response to your business outlook report this week and the extent of the focus on the budget implications of your forecast that the resources investment boom would peak in 2014? Do you think that was a fair representation of the key findings of your analysis?
Chris Richardson: Look, a couple of different issues there. One is, I guess, our key thought that the investment bit of the mining boom, the extent to which the Gorgons and the rest of them that have seen a magnificent surge in development dollars, would see the same degree of dollars in the next few years. What we said was that the investment side of the boom would peak late 2014 and do that for a few reasons. We can get back to those. But one of the reasons is of course that commodity prices have come off a bit and with the investment boom, you know, that simply has an implication some years down the track, not today.
For the federal budget, the impact of lower commodity prices is earlier, not only at coal and iron ore prices but so too is the share market and housing prices in some places. That combination is a challenge for the budget.
SB: The thing that struck me about the report is that it looks quite a distance out into the future. Could you put your view of the phases of the investment boom and its impacts on the economy into some sort of perspective?
CR: Sure. If you look at business investment as a share of Australia’s economy forever, basically it was running in a range somewhere between six per cent in recessions, nine, ten per cent when the economy was strong, but that changed a while ago, you know. China’s boom began almost a decade ago as it moved into a commodity hungry phase of its development. Others are joining it, India for example, and that gives enormous opportunities to Australian businesses, not just the resources sector, though of course the resources sector is a notable part of it.
The business investment slice of the economy, the real economy, is eighteen per cent and still growing stunningly above where it used to be and indeed that means business investment spending spending on new mines, on roads, on ports, on rail, and on other things too, shopping malls, office blocks, computers, equipment, all sorts of stuff. Business investment spending accounted for more than all the growth in Australia’s economy in the financial year we finished a month ago. You know, not consumer spending and not housing construction, not spending by governments, it was all business investment.
And in the year we’ve just started, 2012/13, are almost two thirds of all the growth in Australia’s economy is down to business investment and we do see it, you know, growing not nearly a lot in ‘12/’13, but again in ‘13/’14. But – you know, the big but if you like – it can’t keep growing forever as a share of Australia’s economy. Families have got to be spending something, governments have got to be spending something, and the peak in that investment cycle - the construction impact of the resources boom - we see a handful of years away. No surprise. I mean currently we’ve already spent an absolute fortune and there’s a stunning amount of extra supply in the pipeline, not (only) here but around the world. But a couple of other things too, not merely has China’s economy slowed and led to a modest but important reassessment of how fast China will grow in the longer term, but also a bunch of costs have shifted as well. It’s rather more expensive to build and operate mining projects in Australia relative to other places than it used to be.
Robert Gottliebsen: What you’re saying is that by 2014 that percentage of growth is going to decline dramatically?
CR: Yeah. Or if you think of it as the share of the economy going to business investment where the driver is that resource driven construction boom, we see that peaking sometime late 2014 and moving down. You know, five years from now that would still [indicate] the investment boom is almost as big as today. You know, it peaks two, two and a half years from now and then starts to move down. It’s stunningly stronger than it’s been pretty much across Australia’s recorded economic history, but the peak will pass and in terms of real growth in Australia’s economy, that resource driven business investment – a big component of the two speed split in the economy – won’t be as big going forward. In fact, if you want to think of it as share of Australian economic growth, last year where it racked up more than a hundred per cent, you could argue that in the growth sense [it] was already the peak.
RG: I think that the most dangerous of these elements is the rise in our costs because we’re seeing a) a rise in construction costs, but b) a rise in mining costs and over all that a big fall in productivity compared with the US. Is it true that we’ve allowed this boom to basically mask quite a serious underlying Australian problem longer term?
CR: Yes. And that comes back to, of course, the productivity issue, though some of these questions are specific to mining and construction. Now, some of the things, it’s fair to say that there’s not a lot we could do about them. The exchange rate has moved more substantially in Australia than it has in Canada simply because of the mix of our economy – our industrial portfolio if you like – and the extent to which the mining boom has, through higher commodity prices, pumped money into Australia’s economy means that interest rates, other things equal, are higher in Australia than you see in many other nations around the world. And I think of those two, the strength in Australia’s exchange and interest rates as a deadly duo. You know, they have an impact on everyone. They really do.
You know, we hear the stories understandably enough for the manufacturers and the farmers. They also have an impact on the miners. You know, lest we forget. So, in a sense, we’ve got the tiger by the tail and those costs are exchange rate and interest rate driven. But as you say there’s a whole bunch of other things that are homegrown. Now, again, some of them are hard to avoid. The sheer strength of demand for workers with particular skills needed in particular places at particular times means that wages in some bits of engineering construction and mega mining projects, and what you’re seeing in mining itself, those wages have soared. So too has labour turnover. In some of these places labour turnover is running at forty per cent – an absolute killer for productivity and for costs. You’ve seen costs of materials go up. You’ve seen the delays in delivery of materials go up.
Again you could argue we could do some things about that. Certainly, I’ve not been a fan of what’s happened with migration in the last handful of years and you look at the – he chooses his words carefully, avoiding the word shameful – you look at the public discussion around the Roy Hill enterprise migration agreement, and you see the extent to which to some extent policy is still artificially pumping up costs. Then, there’s the more obvious stuff; the mining tax, the carbon tax, the weight of environmental and other regulation on the resources sector. All of that didn’t matter or didn’t matter as much in the frenetic stage of the boom and, in a sense, the frenetic stage is not yet over, certainly in a construction sense. But you look at the horizon, you know, the miners who are considering weighing up the costs and benefits of the next round of those mega projects and you already see the public statements from a bunch of the miners. They’re going to be more careful.
RG: I suspect a lot of those current projects will be hopelessly over-costed and might not get good returns because they’ve spent much more than they expected on the capital investment.
CR: Yes. And look, that allocation of capital in some cases – there’s a bit of buyer’s regret or constructor’s regret with some of the things that have happened more recently. Costs have just, you know, truly been stunning and, without naming the names of projects, many of them have seen massive cost overruns. Broadly since 2003 in Australia I can’t think of any construction project that was initially costed at a billion dollars that came in on time and on budget.
SB: Chris, the big miners you referred to have been shifting the emphasis of their language from price to volume. Will the big increases in volume we are already experiencing and [the volumes] from the projects that are still under development be sufficient to sustain the kind of economic growth that you’re saying will be three to four per cent over the medium term?
CR: Look, growth will come off and tend to be closer to the three than today’s four and today’s four is of course flattened by the recovery from the earlier floods and cyclones. Yes, the list in export volumes, as the construction peak is evident, but also to some extent the price peak for commodities may well have been edited as well – the volume side of exports helps a lot. Having said that, I do think that people overestimate including not just today’s crop of politicians on both sides, but almost the past decade that there’s been, when I talk to people in Parliament House, there’s almost been the shrug [that] 'sure commodity prices will come down, but commodity volumes will come up'.
And that’s quite true, but you’ve got to think of this as Australia Proprietary Limited and the important thing is that our prices are extremely sensitive to relatively small shifts in demand and that great growth in China. [That's] increasingly elsewhere caught miners around the world by surprise and for a better part of a decade, supply has been desperately struggling to catch up to demand and the shift in prices. You know, many commodity prices have gone up by a factor of four or five. At times they’ve gone up comfortably more than that. And the volume shift that you would need to offset the price benefit to Australia is more than you could ever really expect. You know, mining is now close to 10 per cent the economy but that’s not massively bigger than it was a while ago.
As the banks pointed out, our calculation would suggest, other things equal, the world [has given] us a pay rise from those higher commodity prices since 2003 [which] has basically added, you know, thirteen, fourteen per cent to national income. You won’t see the mining sector and its export volumes adding thirteen or fourteen per cent to real GDP. There’ll be a handy offset, but the magic moment for Australia is the phase in which the miners can’t keep up here and around the world and the prices are staying. We may have seen the best of that already.
SB: That magic moment from your report may have passed us because – I think you said in the report – that global iron ore supply has started to grow faster than demand and we know that there’s a lot more supply in the pipeline. So the potential for a kind of a crash in iron ore and coal prices is much more significant than what we’ve seen is there, isn’t it?
CR: Look, that risk has been around for a long time. Basically, I’m stunned by the number of people who forget that there’s never been a permanent boom in profit margins in anything. And so, I would certainly agree that further growth in China and India and elsewhere means that there’ll be a lot of further growth in iron ore demand, in coal demand in all sorts of coal, a variety of commodities. Some of the miners are now reassessing exactly how much that growth will be, but there’s certainly a lot of further growth from here. But far too many people have drawn a straight line from, you know, great growth in China and India well into the future [which] means great prices for this stuff and, you know, economics is an iron triangle between demand and supply and price. We’ve seen the boom in demand. It will continue. We are just, as a globe, starting to see the boom in supply and commodity by commodity there is a heap of stuff in the pipeline.
We know that the same reasons that have boosted costs here in Australia; that supply has been slow to come on, not just here but around the world, and you can argue, how fast it will rise from here? But economics would say, if there’s no particular shortage of iron ore and coal and other things around the world, that eventually supply would catch up to demand no matter how fast demand grows or how impressive it is, and prices will come down. [You can] obviously point to longer term prices for a bunch of commodities that are pretty low. And you’ve got to remember too, the key is the profit margin. Prices, I suspect, will remain high relative to history but at least part of that will be because costs have moved up for cyclical reasons, but some have moved structurally. You know, the cost of getting some stuff or, a given quality of mineral out of the soil. Those costs have risen over time. The economic impact comes from the margin end.
RG: Chris, the scenario you’re painting, certainly in isolation, means that give ourselves a year, two years and we’re going to see a much lower dollar. The sort of things that have pushed the dollar up, which is capital investment, prices of commodities and, of course, interest rates, will all reverse.
CR: Look, I’d agree with that and, you know, economists aren’t known for their humility, but the closer you get to exchange rate forecasting, even we become a bit more humble with an emphasis on "a bit”. Look, you’re right. As a quick thought for you, we see the exchange rate, at or near parity with the US dollar for about another eighteen months. But the further out you look in time the less likely that is. And partly, that's because supply catches up with demand and commodity prices come down, and that has an impact. Not merely because the Australian dollar is a commodity currency, but also because it takes a bit of steam out of Australian economic growth and takes a bit of pressure off our interest rates. But there’s another factor out there too. Partly because we always try to keep an eye on the medium and longer term, I’m not sure enough people remember a crisis. The extremely low interest rates, official interest rates, in much of the world that we see at the moment, that is not a permanent feature of the landscape. I know it’s lasted a long time in Japan, but there are some specific reasons. You won’t have near zero interest rates in the US, UK, Europe, indeed even in Japan forever. And as and when those interest rates start to go up – the US Fed for example are signalling 2014 – it does take another leg of strength away from the Australian dollar.
RG: Could I put to you a more controversial view that some of the efforts we’re doing now to maintain the number of manufacturing type businesses – whether they be automotive or aluminium that are a real pressure now but that pressure will change dramatically in two or three years – that we would actually be quite wise to try and keep these businesses going through this period, so that when they get into a bear environment we’ll still have them, but if we let them go, they’ll be gone forever?
CR: Look, I can understand that argument. With my evil economic rationalist hat on - it’s a well worn hat - I would be more cautious. But look, I think you’re right. You look at pressures on manufacturing and on other sectors, you know, tourism, international education, farming. I do think the intensity of today’s pressures is, again, not a permanent feature of the landscape. Now, to look a manufacturer in the eye and say, ' look I forecast the Australian dollar to come down', well trust me, is a difficult thing to do. You know, today, this week, next month, they can expect to lose money in many cases and economists can promise what they like, but business people have to make difficult decisions based on an assessment of where things may be likely to go. Having said that, [there are] two things worth remembering: the degree of structural change in Australia’s economy may be faster at the moment, but it’s still slow.
Even at the end of this process, even after the top of the construction boom, even after, you know, commodity prices come down somewhat, you would still assess the fact that half the world is having an industrial revolution and that commodity prices will be higher than they were in times past. You know, I would translate that into plain English that says, the world will continue to beg for Australian resources and there will be a continued need for a structural shift in Australia’s economy, not just because technology and other things as well. And I do think those structural changes are... they’re permanently lagging – where in a sense the world economy and technology possibilities would otherwise have them. So, first thought – I can understand the thought well – [is] maybe we should tip some public sector money in to keep some doors open if we don’t think current conditions are forever. My first response would be, well, any element of current conditions will still last. Second, lest we forget, there’s still a lot of government money going to all sorts of businesses. Industry welfare is a very large component of the budget. It has been for a long time. If we were to do something there, if we were to make the judgement, 'well let’s try to get some people through a difficult patch', I would prefer to rejig a chunk of that industry welfare rather than add to it if you like.
SB: Chris, you say in the report that you don’t expect a global double dip recession, but that it is possible. Is an implosion in Europe the most likely catalyst for another crisis and recession and how likely is that?
CR: Look, it does keep me awake at night. You know, the euro zone, [is] a political triumph in many ways, but tying seventeen nations together with one currency is an economic accident waiting to happen. And too many people focus on this as some sort of a liquidity and debt issue and sure, those are important, but more important, for my mind, is the solvency issue. You could wave a magic wand and forgive all the public sector debts in Europe and Europe would still have big problems. You know, since the euro was created, wages have risen eighty per cent faster in Greece than they have in Germany. It’s thirty per cent for Italy, forty per cent for Spain and, other things equal, even if the debt went, Greece Pty Limited, Italy Pty Limited, [are] not competitive at euro exchange rates given what’s happened to wages in the meantime. And so, I do see lingering problems there. You know, we won’t be able to avoid those. You know, markets can act faster than politicians can react.
SB: If there were another implosion… If there were an implosion in Europe, do we have sufficient capacity to respond as we did in 2008?
CR: We do have heaps of capacity and most notably sitting with the Reserve Bank, even though rates today are rather lower than they were when the global financial crisis hit. It’s probably true with the benefit of hindsight that last time the Reserve Bank should have done more and the federal government should have done less. So, the fact that interest rates are already lower… you know, it doesn’t for me change the thought that the Reserve Bank’s got a lot of ammunition there. Having said that, where I think the situation is different, not just here at home but around the world, is that fiscal response. Debts and deficits have politicians terrified here and around the world and would we see the same degree of government spending and tax relief in response to every new crisis? No we wouldn’t. And the Reserve Bank’s ability to move here at home is not matched by the Fed, by the Bank of England, by the ECB and others out there. So, I’d be hopeful that if there were a renewed crisis, it would be smaller. Fewer banks would go bust but I suspect that the policy response here at home and around the world would also be less.
RG: But Chris, if we are going to have a crisis and the euro splits and that causes a substantial problem in the wholesale banking market. That means that our banks will have far less overseas money and [will] have to raise that money in local deposits. And so the sort of crisis we’re looking at this time, and I know predicting crises is very hazardous, is a banking crisis and need to replace deposits crisis. And that is not easily handled by some of the conventional methods.
CR: Yes. And in effect, no matter how much the Reserve Bank cuts official rates, the margin above that that the banks and others in Australia end up charging Mr and Mrs Suburbs or indeed, companies for funds, may not drop much at all...
RG: They may even be up, Chris.
CR: Yeah. And look, certainly for riskier stuff it would go up. You’re quite right that the risks in and around the cost of capital have always been there for Australia. As a nation we spend more than we earn. Now, luckily a lot of that has been, you know, this investment surge and that should give us long lasting assets. You know, you can argue the size of the return, but we’ll get a return there for a long period of time. But it also means that as a nation we rely on the kindness of strangers. We rely on the ability of, in particular, our banks to raise money overseas to plug the gap between what we spend as a nation and what we earn as a nation and that is a key vulnerability for us. The International Monetary Fund’s noted it forever. It was evident during the global financial crisis and it’s the key.
You can think of the transmission effects from a renewed crisis on Australia. Credit would be a big part of it. There is a risk that, as you say, for some people credit would go up rather than down. Commodities would be another big part of it. Not that the quantity we would sell of coal and iron ore and the rest of them would go down that much, but the prices we earned would be really quite affected. And confidence is the other thing. You know, as people read and hear about the renewed crisis, that has an impact on their confidence and hence on their spending. Those three, credit, commodities and confidence – the three Cs – are what we risk in the next crisis, if it happens.
RG: You’re making us very scared , Chris.
CR: Well look, you know, it’s not what we expect. We do expect Europe to muddle through and Treasurer Wayne Swan has got a lovely phrase of saying, you know, the Europeans and perhaps, in particular, the Germans remain one campfire ahead of the posse. Hopefully they can continue to do that. And the slowdown that is in China and, I think has been more than the authorities there expected – at least in part because they deliberately engineered [a] slowdown and ran into Europe and other difficulties. [Now] they’re stomping on the accelerator there again. Sadly that means an economy that’s already too reliant on infrastructure is again looking to another round of infrastructure stimulus. But our expectation is [that] Europe muddle[s] through, China’s growth dips a little further before coming back up again towards the end of 2012 and, you're much happier in 2013 and Australia’s economy continues to do better than people realise. And we called our report ‘The Glass Half Full’ – apologies to Glenn Stevens stealing his words of a couple of weeks ago. But it is a glass half full. Twenty-one years of growth without a recession, amazing. You look at our unemployment rate, our inflation rate, you add the two together to create the 'misery' index as it used to be known and in Australia it is a 'happy' index. You add inflation and unemployment you get the lowest total here in Australia since the 1960s and yet sentiment is where it is.
SB: Chris, on that far more positive note, can we wind it up?
CR: Thank you very much.
SB: Thank you. We appreciate it.
RG: Thank you.