Our high dollar threatens living standards

A higher $A will spell danger for our economy as non-commodity exports become more uncompetitive.

Summary: Australia’s economy is in transition, with some commodity prices in decline and the resources capital investment cycle slowing. Australia’s external position remains in a state of flux as declining capital imports are offset by declining commodity prices, which are also offset by increasing volumes.
Key take-out: On any view of the direction of the $A it seems prudent for Australian investors to consider offshore investments to either benefit from a weakening $A or to minimise the economic consequences of a higher dollar.
Key beneficiaries: General investors. Category: Economics and investment strategy.

In recent days we have seen senior Reserve Bank of Australia spokespeople and some leading Australian economists suggest that our national income, and therefore our standard of living, may be under threat if the dollar does not depreciate.

Their focus has been on the end of the resource capital investment boom and they suggest that gains in exports will not be shared equally across the economy without a dramatic economic transition.

At the outset I draw your attention to the following chart that illustrates Australian wage earners are already experiencing a fall in real wages. In the private sector, the recent year has seen the lowest growth in wages since the 1992 recession.

The recent lift in the unemployment rate to about 6% and the drop in Australia’s workforce participation rate are indicative that wages growth will remain subdued. The deregulation of labour markets that has progressively occurred over the last 25 years has ensured that the (arguably) excessive wages paid at the peak of the resource capital cycle did not flow across the economy. Further, deregulation should encourage future wage increases to be based on productivity rather than merely reflecting inflation plus a margin.

The extent of the resource capital cycle is shown by the next chart of the last 20 years. In the financial year 2012-13 mining investment consumed nearly 45% of all business investment. Its longer-term average from 1992 to 2005 was less than 15%. The transition of the Australian economy is continuing and less capital investment will be required for fewer new mining projects.  Indeed, much of the capital investment will be directed to the maintenance of established resource projects.

There is a clear cyclical investment downside developing once the major LNG projects are completed by 2016. The offset should be a major lift in infrastructure investment by Commonwealth and state governments – but there is little confidence that this will occur.

The substantial lift in mining capital investment from 2005 to the present day is responsible for the discernible lift in the export volumes of resources. It is noteworthy that today, on a quarterly basis, the value of the exports of resource commodities exceeds by over 50% the combined value of all other major export categories.

The extraordinary growth in iron ore exports appears unrelenting, and based on recent ASX market announcements by BHP Billiton (ASX:BHP), Rio Tinto Limited (ASX:RIO) and Fortescue Metals Group (ASX:FMG) it appears that Australia will produce iron ore exports at a rate of over 200 million tonnes per quarter in 2014-15. This is double the rate achieved in 2009.

Whilst export volumes of iron ore have doubled, it is observable that its spot price has halved over the same period. The fall in coal prices has been more dramatic. Therefore, in retrospect, shareholders and indeed all Australian citizens must question the logic of both BHP and RIO in not locking in long-term iron ore pricing with Chinese buyers. Whilst the massive expenditure of capital was justified by predictable volume increases into the emerging Chinese market, our major iron ore producers have created significant investment risk by not securing certainty over export prices.

Across a range of commodities Australia is now experiencing a dramatic fall in export prices. At this point no-one is forecasting prices to settle back to 2000 levels and the recent price corrections have been from historically high price levels. The mid-point from 2000 levels to the peak in 2012 is an RBA index level of 80. Should prices move to that mid-point, then another 5% to 10% decline in prices would occur. Whilst that is not a prediction it does show the influence that China’s growth surge had over commodity prices. This demand surge is now being met by substantial increases in supply and prices are correcting.

The elevated $A and the surge in mining capital investment has had a dramatic effect on the components of imports. The next chart (Figure 8) shows the extraordinary surge in capital item imports over the last 10 years. The high dollar simply made Australian-produced heavy engineered products uncompetitive with imports. The good news is that the fall in capital imported goods should help hold the Australian trade account in surplus. This was most noticeable in the March quarter when the drop in capital imports was significant.

However, Australia’s external position remains in a state of flux as declining capital imports are offset by declining commodity prices that are also offset by increasing volumes. The current account deficit has improved from both an improved trade account and the income flowing from increased offshore investment by Australian super funds. Also the lower level of interest rates means that our debt servicing costs on offshore loans has decreased. All of this suggests to me that predictions for the longer trends in Australia’s external position are way too difficult to make at present.

So, in conclusion, I do see that Australia has moved through a fortuitous period of high commodity prices. That period has ended as we now move into a period of volume growth. What is unknown is the level at which commodity export prices will settle. So from this point on I do perceive that Australia’s national income and therefore its standard of living will be dramatically determined by the level of the $A. I maintain that a higher $A will spell danger for our economy as non-commodity exports simply become more uncompetitive.

Conclusions

The downturn in commodity prices that has occurred has offset the benefits of the massive lift in export volumes that eventuated from the resource capital investment cycle. Should weak prices continue without a sustained devaluation in the $A, then the predictions that the Australian economy will become challenged should in my view be taken seriously. On any view of the direction of the $A it seems prudent for Australian investors to consider offshore investments to either benefit from a weakening $A or to minimise the economic consequences of a higher dollar.


John Abernethy is the Chief Investment Officer at Clime Asset Management. Clime offer excellent performing growth and income portfolios through its individually managed accounts service. To find out more, or to request a review of your share portfolio, call Clime on 1300 788 568 or visit www.clime.com.au.