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Adam Bowe, Robert Mead
Throughout the investment phase of the mining boom, many small communities across Australia have grappled with the question of whether to passively accept the large mining projects planned for their region – along with their economic benefits – or examine more closely the longer term risks: environmental implications, the possible crowding out of local businesses as demand for labour and capital increases, and most important, what will remain of the local communities once the mines have been built.
This last risk – what will remain – is a challenge that the Australian “community” in aggregate will face over the next year. With mining investment contributing over 60% of the growth in real GDP last year, policymakers need to ensure that more is left than just a very big hole – both physically and economically – as the peak of the mining investment wave passes over this year.
We believe that lower interest rates will likely be required to support domestic demand as Australia transitions away from mining-assisted growth.
Headwinds to growth In 2012, engineering construction, which is primarily mining investment, contributed 1.9% to total real GDP growth of 3.1% (Figure 1). As this growth engine begins to fade away over the balance of 2013 and likely detracts from growth in 2014, Australia must turn to other sources of domestic demand to fill the economic hole.
The peak in mining investment comes as Australia’s economy already faces a significant challenge. On the nominal side, the end of the boom in bulk commodity prices has put pressure on the terms of trade, which is likely to continue as China’s growth moderates and Chinese policymakers attempt to transform their growth model away from infrastructure investment towards consumption. This will continue to put pressure on Australia’s national income growth – already at low levels rarely seen outside recessions (Figure 2).
Growth candidates So what growth options are available to fill the hole left by the passing of the mining investment boom? Let’s review some of the obvious candidates.
Fiscal policy? Unlikely. We expect that the growth in national income available to be taxed at the federal level will remain subdued over the secular horizon, and absent a significant fiscal consolidation, the budget will likely remain in deficit for a couple of years yet. So the flexibility of fiscal support will remain restrained unless the government actively decides to increase debt levels substantially, which, while possible, is not our central expectation.
Housing construction? Potentially, but only modest. The good news is the recent improvement in building approvals data indicates that housing construction has the potential to contribute to growth this year. However, this sector of the economy represented less than 5% of GDP in 2012, so even a rebound to longer-term average growth rates of 4% from a 0.8% contraction last year would only contribute 0.2% to total real GDP growth.
Non-mining business investment? Potentially, but will likely need additional incentives. Business investment outside the mining sector has sustained considerable headwinds over the past few years, namely the strong exchange rate and competition from the mining sector for a finite amount of available domestic labour and capital. This has resulted in a noticeable crowding out of non-mining business investment, which has fallen to less than 12% of GDP from over 15% in 2008. Some of this will be permanent as a long-term structural adjustment to a permanently larger mining sector (which we characterized as “Dutch Disease Lite” in an April 2012 Viewpoint). And some of this will be cyclical and potentially responsive to easier monetary conditions. But importantly, business investment decisions have long lead times, and every day that the exchange rate remains strong and domestic policy settings aren’t easy enough is another day that businesses delay making investment decisions that would likely take many months to reach the execution stage. After a five-year decline in non-mining business investment as a share of domestic output (Figure 3) and while global uncertainty remains elevated, we expect that additional incentives will be required to encourage this sector of the economy to meaningfully increase its contribution to growth.
Household consumption? Already at trend. Consumption has actually been one of the bright spots outside the mining sector in an otherwise subdued domestic economic landscape. Households have been consuming at close to old growth trend levels of 3.5% over the past two years. So the real question is: Do we expect household consumption to grow significantly above trend in the current environment and help fill the mining investment growth hole? We think this is unlikely for two reasons. First, household balance sheets remain highly leveraged, with debt-to-disposable income stubbornly stuck near all-time highs at around 150%. Additionally, employment growth has been below average and wage growth is moderating. Like the Reserve Bank of Australia (RBA), we expect the unemployment rate to rise over the cyclical horizon and believe lower policy rates will be required to maintain trend levels of consumption.
External demand? Unlikely over the cyclical horizon. The recent surge in mining investment will likely bear fruit over the long term in the form of higher commodity exports. However, this is not expected to add meaningfully to growth until we move through 2015 and production comes on line. Also, we expect global growth to remain subdued over the next year or so, and specifically, we expect growth in China to continue to moderate towards 7% – not an environment in which we would expect to see a boost to domestic growth from greater exports. Nevertheless, net exports could potentially improve at the margin as mining investment winds down and imports of the capital goods used in many of the resource projects decline.
Monetary policy: meaningfully easy? Although a 2.75% cash rate looks exceptionally low relative to Australia’s historical experience, it still leaves the RBA with plenty of firepower to combat a slowdown in the domestic economy. To stimulate some of the domestic growth candidates like non-mining business investment, household consumption and housing construction, we believe the RBA will need to provide meaningfully easy policy rates. The RBA already attempted higher policy rates after the financial crisis, hiking rates to 4.75% in 2010, but it was clear the economy couldn’t handle these levels – what would have previously been considered relatively low interest rates – and as of early May 2013 we are at new lows in policy rates.
This begs the question: Is 2.75% not meaningfully easy? Not based on our estimates. Prior to the global financial crisis, the neutral cash rate in Australia was widely estimated to be around 5.5%. So what has changed? Most important, as of April this year, the interest rate at which households can borrow to fund the purchase of a home is roughly 1.5% higher relative to the cash rate than before the crisis. And it is end-borrowing rates that matter to the RBA, not the rate at which banks lend to each other overnight. So that variable alone means the neutral cash rate would be closer to 4% today.
Two other important variables have also changed significantly in recent years. First, the exchange rate is more than 30% higher in trade weighted terms than its average when the neutral cash rate was around 5.5%. This places a significant economic restraint on many domestic industries, which the RBA attempts to compensate for with a lower policy rate. And second, real growth, both global and domestic, has been materially lower over the past five years. Trend growth in Australia was historically 3%-3.5%, but Australia has only managed to grind out an average of 2.5% since 2009 – despite the economic windfall from the mining sector. The higher exchange rate and lower real growth are in turn reducing the neutral cash rate to a “new neutral” level, which we estimate to be about 3%. So is 2.75% meaningfully easy? We don’t think so, and we think the RBA will need to ease policy further over the cyclical horizon. In our view, even a casual review of recent domestic growth, inflation and employment data supports the notion that policy is not currently meaningfully easy.
Investment implications After avoiding the worst of the ravages of the global financial crisis with the aid of significant policy stimulus from China that helped boost demand for bulk commodity exports, Australia has so far escaped the clutches of the global New Normal. However, as domestic growth outside the mining sector remains subdued and Australian policy rates appear likely to converge towards their global peers’, we believe the New Normal has finally arrived down under. Although the return on mining sector investment will surely come over the secular horizon in the form of higher exports, the expected decline in mining investment will likely leave a significant economic hole over the shorter term that will need to be filled.
With fiscal policy restrained, we expect other domestic growth sources like non-mining business investment, household consumption and housing construction will require meaningfully easy monetary policy conditions as an incentive. We estimate that a 2.75% cash rate is only modestly easy at best in Australia’s New Normal, and the burden of policy stimulus is likely to continue to fall on the shoulders of the RBA. In our view, falling domestic policy rates should support domestic bond prices, with interest rates likely to stay low for some time.
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