The new growth model

31 August 2010

The Australian economy is becoming increasingly dependent on a narrow source of growth. While business investment is the notable bright spot, this strength is now totally dependent on strong mining investment. And even within mining, the sources of growth have become more concentrated with a few very large projects driving growth.

While the need to ‘make room for the mining investment boom’ has been well observed, it is also worth noting that the very nature of growth driven by a few large mining projects could be very different than in an economy with balanced growth. In particular, growth is likely to be much more volatile and erratic on a quarterly basis and be vulnerable to substantial revisions (in either direction). This will not only make it more difficult for investors to assess the underlying momentum in the economy but it could also make it more difficult for policymakers to anticipate turning points in the economy.

Over the past two decades, private sector investment has grown as a share of the Australian economy. In the year to March 2010, this proportion was close to ¼ of total economic output, and this will rise further in the year ahead. The difference to previous years, however, is that the bulk of these spending plans are coming from a single sector.

While the mining sector is generally responsible for about 1/3rd of total business investment, it is expected to generate more than 75% of growth in investment over the 2011 financial year.

While spending in the mining sector will be booming, other areas of the economy are anticipating a flatter period of investment growth. At the same time, labour shortages and strong wages growth associated with a mining boom will place upward pressure on interest rates, which will keep household spending growth at a fairly moderate pace.

This will not only impact the composition of economic growth in Australia, but also the shape of the economic cycle. Spending in the mining sector is more volatile from quarter to quarter compared to investment in other sectors of the economy. Moreover, it is certainly more volatile than consumer spending.

The implication of this is that issues such as bad weather or production delays could have a marked impact on quarterly GDP growth, even if they don’t alter the longer-term economic outlook.
This would make life difficult from a policy perspective, as the Reserve Bank tries to balance a very strong outlook in one sector, while some of the more visible areas of the economy are softening.
Along with a potentially more volatile profile of growth, investment in the mining sector is inherently more risky as well. Based on historical realisation ratios – which show the degree to which firms upgrade or downgrade capex plans over the course of the year – the mining sector is more susceptible to investment downgrades than other industries.

This increases the risk of a short and sharp downturn if mining investment falls at the same time as household spending is being held back by higher interest rates. And this risk is exacerbated because even within the mining sector, the drivers of investment have become more concentrated. That is, while the value of planned developments in the mineral and energy space is massive, there are fewer projects than in previous years.

This is particularly the case with the range of large-scale liquefied natural gas (LNG) developments. Examples of this include the planned $43b capital expenditure for Gorgon LNG, as well as other massive potential LNG projects, which are at a less advanced stage – such as Australia Pacific LNG ($35b) and Wheatstone LNG ($20b).

The implication of having a smaller number of more valuable developments is that any delays or cancelations of individual projects could have a far more dramatic influence on economic growth than would otherwise be the case.

This degree of risk can make it more difficult for policymakers to strike the right balance in terms of dampening household spending to accommodate the planned upswing in mining investment. Indeed, while the outlook for investment is strong, there is a risk that as the economy becomes increasingly dependant on the mining sector, a temporary lull in development activity would generate a very weak quarter of GDP growth. And, this could have the potential to undermine confidence in the economy.