Let's talk about Capex

01 June 2011

Upbeat growth forecasts from the Treasury and RBA are based on very optimistic forecasts for private sector business investment.  But, if the RBA’s investment forecasts are too optimistic, not only will investment be weaker, but so too will consumption and housing, as weaker growth results in less income growth and declining confidence.  This would not only mean that tighter policy was not required, but even that current policy settings could be too restrictive.

The RBA and Treasury forecasts for business investment over the next couple of years are truly extraordinary.  Treasury expects non-residential construction to double by mid 2013, while the RBA forecasts are predicated on mining investment doing the same thing.

To put this in perspective, the expected lift in mining investment is equivalent to doubling new housing construction from 150,000 units per year, to 300,000 dwellings in the next 2 years.  Another way to look at this is that the value of mining investment in the next 2 years is expected to be the same as all the mining investment that took place between 1989 and 2006.

Now the RBA acknowledges that it is possible “that the considerable complexity of some of the large planned projects results in the pick-up in resources investment occurring more slowly than is envisaged”.  However, it thinks that ‘the greater risk’ is that the mining investment boom creates even more inflationary pressures than suggested in its forecasts.

So why are the Treasury and RBA so confident about these forecasts, and is their confidence justified?

To be sure, there are plenty of investment projects in the pipeline.  The Access Investment Monitor estimates that there is almost $800bn of projects currently under construction or proposed.  At the same time, the Statistician’s survey of capital spending intentions (the Capex survey) is also pointing to remarkable growth in investment over the next couple years.

A literal reading of the Capex survey suggests that building and construction investment will increase by more than 100 per cent over the next 2 years, from $52bn to $106bn.  Mining investment is expected to increase from $35bn to $87bn, an increase of 148 per cent.

But is this really a true reflection of investment that will take place over this two year period?

In our opinion, achieving such stratospheric growth would be extremely difficult.  For example, during the largest mining investment boom in Australia’s history, investment increased from about 1 per cent of GDP to 3 per cent of GDP.  That is, it took 5 years for mining investment to increase by 2ppts of GDP.  Now, the RBA and Treasury expect mining investment to rise by 3ppts of GDP over a couple of years.

In 2004-05, however, the level of mining investment was still below that achieved in 1997-98, which suggests that there was plenty of spare capacity in the sector that would have enabled investment to rise relatively quickly before hitting capacity constraints.  Now, however, the stories about capacity constraints affecting mining are everywhere, from the lack of housing in mining towns, to the shortages of skilled labour, to the inability to book flights into mining towns.  To imagine that activity can now double from this already high level appears very optimistic indeed.

Now there is one way in which resource companies could boost investment significantly and by-pass capacity constraints.  And this is simply if the additional capacity is imported rather than built in Australia.  Of course, there is limited scope to do this when adding capacity to iron ore mines or coal production.  But for LNG production this is certainly a pertinent consideration.

Even so, this doesn’t appear to explain a great deal of the expected strength of investment and its flow on to higher GDP growth.  This is because if the growth in investment is achieved by installing a $10bn LNG platform that was constructed in Thailand or Singapore, then the $10bn boost to investment will be offset by a $10bn drag on GDP growth from imports.   According to Treasury forecasts, however, import growth over the next couple of years is expected to average around 9.5 per cent, only marginally stronger than the 9 per cent growth forecast for 2010-11.  And while this pace of growth is above average, it can be explained by the strength of the A$, the recovery in consumer spending and the general strength of equipment investment, rather than reflecting any particular switch in the composition of mining investment.  

So, the investment bulls will claim that even if mining investment grows at only half the pace suggested by the Capex survey, it will still mean that mining investment will be very strong.  And we are certainly not disputing that mining investment will be very strong.  But whether mining investment doubles in the next couple of years or increases by 50 per cent does matter hugely for the economy.  If it is weaker, GDP growth won’t be above 4 per cent, and income growth, housing activity and consumer spending will be even weaker than they are now.  

By putting all their eggs in the mining investment basket, policymakers appear to have no Plan B for what will support the economy if investment disappoints.  And this note provides three clear reasons why one should be cautious about counting those mining investment chickens before they are hatched.