Making room for the mining boom

12 April 2010

The return of soaring commodities prices is once again set to assume centre stage in the Australian economic debate.  While other developed economies fret over high levels of unemployment, ballooning government debt levels and budget deficits, frail bank balance sheets and jittery sentiment, the main issue for Australia is the same question it faced in 2007: how should policymakers make room for the mining boom?

The strength of the key commodity prices for Australia – iron ore and coal – is, of course, underpinned by the ongoing buoyant levels of demand emanating from China.  The importance of China as a trading partner increased enormously during the global financial crisis, at the same time that demand from other developed economies collapsed.  And while some analysts continue to suggest that China’s growth is illusory, the fact that commodity prices continue to rise suggests that demand is in fact very strong.

There are many implications of the rise in commodity prices for the economy.  For example, higher commodity prices will feed through to surging profits and hence company tax revenue.  At the same time, higher commodity prices could push up the A$, although our research suggests that interest rate differentials have been a more important driver of the currency in recent years.

But far and away the greatest impact of strong demand for commodities is the effect on business investment.  And it is how policymakers respond to this surge that will determine the fate of the other sectors of the economy, including retail, housing and tourism.

Business investment is now a larger share of the economy than it has been in many years, which reflects the sustained period of strong growth since 2001.  Hence, movements in business investment are now far more important than they have been in recent decades.

If that was the only thing driving the economy, then the economy would be growing at a healthy, but not excessive pace.  However, other key sectors have also built up a head of steam.  Housing construction looks set to rise by around 20% over 2010.  Meanwhile non-residential construction is also being boosted by significant government investment from the Building Education Revolution program.

As the school building programme winds back in 2011, this will release workers to return to the housing sector.  But in the interim, we have an industry bottleneck where there is not sufficient skilled labour to support demand.  And the returning strength of business investment will only exacerbate this issue.

And while the construction sector is the most obvious example where capacity pressures are returning surprisingly quickly, it is unlikely to be the only example.  Indeed, the key difference between this recovery and previous cyclical recoveries is that the economy began the recovery with a relatively low unemployment rate.

The upshot of stronger business investment, rising employment and accelerating wages growth is that inflation will be higher in the coming years.  In its recent Statement on Monetary Policy, the Reserve Bank Board noted that the economy was recovering with "less spare capacity than earlier thought".

Essentially, this means that policymakers will once again need to be prepared to put the squeeze on household budgets in order to rein in consumer spending and housing market activity.  Amazingly this looks to be a very similar scenario to that faced by the RBA just two years ago.  At that time, the cash rate rose to 7.25%, taking the standard variable mortgage rate to a very high 9.6%.

This achieved the desired result, with consumer spending and housing market activity contracting sharply during 2008.  This time around, policymakers appear intent on bringing monetary policy to a neutral setting (~4.75%) before the end of the year.  Moreover, the broad-based strength coming through suggests that another 1ppt increase in the cash rate beyond this is likely during 2011.  Of course, much of this will greatly depend on the way in which households respond to rising mortgage rates.

So, while the outlook for the Australian economy in general is very strong, there will be winners and losers amongst different industry sectors and geographic regions.  Foremost among the winners will be those areas with exposure to the rampant investment in the resources sector.  Accordingly, WA and Qld should benefit from this investment.  But, at the same time, this could generate an environment that is very difficult for those firms competing with cheaper imports and with exposure to household spending in the South Eastern States.