Below is a video from the FT that I showed my A2 class this morning. The significance of it is the Australian dollar and how its value is strongly linked to iron ore prices. Recent growth in China has exceeded expectations and this has led to a rebound in commodity prices especially iron ore. The belief is the AUS$ is higher than the equilibrium level suggests and that this rate will not be sustainable. There are two reasons for this:
- Commodity prices have accelerated which has led to more demand for AUS$ which might not be sustained.
- Higher relative interest rates has made the AUS$ strong as ‘hot money’ has been attracted in the country. The Reserve Bank of Australia (central bank) has recently cut the cash rate (interest rates) to 1.75% and there is talk of a further cut this year.
Here is graph from the recent Westpac Bank Economic Overview. It shows how closely correlated the New Zealand and Australian economies are with regard to the % of GDP from the quake related reconstruction in New Zealand and the iron ore boom in Australia.
The Canterbury rebuild will peak around late 2016 and into 2017 although growth after this point will be fairly subdued. The falling exchange rate and lower interest rates will act as a buffer but the dwindling rebuild with become a drag on GDP in New Zealand.
Australia has also experienced a slow down with a reduction in mining construction amid falling iron ore prices. To stimulate growth the Reserve Bank of Australia has cut the cash rate from 4.75% to 2.0% and the Australian dollar has fallen about 30%. However high unemployment and low business and consumer confidence have been prevalent in the economy and growth prospects are very modest for the next few years. This is similar to what New Zealand can expect.
From the National Australia Bank – The slowdown in China and weak bulk commodity markets has seen Australia’s trade deficit blow out again in recent months, hitting a record in April but remaining very high at a deficit of $2,750mn in May under pressure from Australia’s declining terms of trade from the softening in Chinese import demand (and higher export supply) for Australia’s major bulk resource commodities. Interesting to note the importance of China as an export destination
Both Australia and New Zealand face the worrying prospect of the impact of lower commodity prices. For Australia it is iron ore whilst across the Tasman it is the dairy industry. So how will each economy be affected by this?
The whole milk price has fallen from:
US$4999/tonne on 18th February 2014 to US$2270/tonne on the 16th December – a 54.6% decrease.
This downturn in prices will have a significant impact on the rural economy of NZ. The lower prices will not only reduce dairy farmers’ incomes, but there will be a knock on effect in other parts of the local economies as farmers and contractors will be less inclined to spend or invest in anything but necessities.
Short-term credit facilities will be able to help farmers with their costs but permanent lower returns would cause a rethink regarding production capacity and economies of scale.
Aussie Iron Ore
For Australian the iron ore prices have fallen from US$136 a tonne December 2013 to US$68 a tonne December 2014. This will have a major effect on their economy for the following reasons:
Iron ore represents 25.5% of exports from Australia
Iron ore producers are significant tax payers to the Australian Government. The drop in prices = AUS$18 billion loss of revenue
Lower prices mean less investment in capital – this sector has been a major part of the Aussie economy over the last few years
Who will take the biggest hit?
It is expected that Aussie will take the biggest hit mainly because of the tax revenue lost through lower iron ore prices. In NZ dairy farmers are not big tax payers and the NZ government are not expecting a big fall in tax revenue. Furthermore overall economic activity is largely unaffected as milk production is likely to continue in the short-term. However the falling unemployment rate in NZ and a rising level in its Trans Tasman neighbours suggests NZ is in a much better state to weather the storm. Other indicators below favour NZ. These include GDP growth and consumer confidence as well as having the ammunition of being able to cut interest rates further, a situation that Australia might find difficult.
Source: NZ Herald December 20, 2014
From the National Australian Bank – non-mining GDP growth is already running at around or slightly above trend at around 2.75%. This improvement accords with the message of sectoral business conditions in the NAB survey. In 2011, interest rate markets ignored the strength in mining and correctly priced off the weakness in the non-mining economy. Non-mining GDP growth is already running at around or slightly above trend at around 2.75%. This improvement accords with the message of sectoral business conditions in the NAB survey. In 2011, interest rate markets ignored the strength in mining and correctly priced off the weakness in the non-mining economy. While it’s much too early to make the reverse conclusion, especially given the pick up signalled is only very mild, it’s certainly a scenario worth monitoring as it would be a major surprise for Australian rate markets.
I was surprised to read in the NAB Australian Markets Weekly that for the past three years real income per person in Australia has been falling and is now back to levels that were evident in late 2008. The graph shows the level of real income per person with the recessionary periods marked in grey. From the last recession in 1991 up to the Global Financial Crisis in 2008 Australians have experienced a continued rise in the level of their real incomes. Nevertheless how can it be that with GDP growing at about 3% a year real levels of income have been falling?
1. Growth in aggregate real GDP has been boosted a great deal by the sharp growth in the population – Australia’s population grew 1.7% in 2013.
2. While Australia are seeing good growth in the “volumes” of GDP, particularly as some of the new mining capacity has been coming on stream, they are receiving lower prices for this output due to falling commodity prices.
As a nation, they are working harder for less income.
The graph from National Australia Bank below shows the components of Australian GDP March Quarter 2014. This is particularly useful when doing GDP Expenditure approach in Unit 5 of the A2 Cambridge course where you can breakdown the equation C+I+G+(X-M).
C = Private Consumption
I = Business Investment
G = Government Demand
(X-M) = Net Exports
Consumption is still the largest contributor to Australia’s GDP. Over the next couple of years GDP is expected to grow around 3% but key to meeting that target is a solid consumer sector. Household consumption growth in recent quarters has been solid, contributing 0.3 percentage points to growth in Q1 – only exports have contributed more to growth over the past year. However sustaining solid consumption growth in years ahead requires the labour market to improve and consumer confidence levels to recover from their recent lows.
Below is an interesting look at the components of GDP in Australia. Capital intensive and net exports are the mainstay of growth this year. However it wasn’t always like this and notice the changes in consumption that reflect the GFC and the role of net exports in the recovery. Remember the equation:
AD = C+I+G+(X-M)
Since the Aussie dollar was floated in 1983 its value closely followed that of its commodity exports – see graph from The Economist. However since 2003 commodity prices have increased 400% but the dollar rose by much less and no longer had a direct relationship to commodity prices. There are 3 possible reasons for this:
1. The deregulation of financial markets which facilitates the ease of currency trading
2. The current account deficit in Australia which got to 6.2% of GDP in 2007
3. Interest rates in Australia up to the GFC were realtively low compared to other developed countries
2011 saw commodity prices drop but the Aussie dollar has remained strong. As most economies employed a lose monetary policy and proceeded to drop interest rates aggressively after the GFC, the Aussie economy didn’t in fact go through a recession and its interest rates remained relatively strong – see below.
Although a weaker exchange rate could help the Aussie economy especially as it has been susceptible to the resource curse – the strength of the exchange rate and higher interest rates is already putting pressure on some industries, particularly the tourism, manufacturing, education exports and retail industries.
The graph from National Australia Bank below shows the components of Australian GDP from 2007-2013 with forecasts for 2014 and 2015. GDP consists of C+I+G+(X-M) so from the graph you can see that:
C = Private Consumption
I = Business Investment
G = Government Demand
(X-M) = Net Exports
* There is anticipated an increase in non-mining investment with investment in the mining sector slowing down as completion nears.
* An increase in private consumption as well as net exports holding its own.
* The relationship between business investment and the increase in net exports
* Pace of growth is below the trend over 2014-2015 which means that that population growth will be greater than the number of new jobs created.