The standoff between the President and the US Congress continues after the Government was forced to shut down non-essential services and stand down more than 800,000 employees.
US politicians appear no closer to resolving the deadlock. But while markets remain frustrated with the current situation, a resolution is hopefully not too far away. For Australia, the impact on the local economy is unlikely to be significant if the issue is resolved before too long. With over 80% of Australia’s exports destined for Asia, any hit to Australia’s trade accounts will likely be undetectable. Source: BNZ Australian Markets Weekly
Here is a graphic from the National Australia Bank which shows a good correlation between the demand for full-time and part-time workers and business confidence. In Australia for five of the last six months, full time employment has fallen. This is a sign that employers lack of confidence in the outlook makes them reticent to hire on a full time basis. Instead they are preferring to hire people on a part time or casual basis which gives them a lot more flexibility in uncertain times.
A little over a decade ago the Australian dollar was being dismissed as the Pacific Peso but today some are referring to it as the Swiss Franc of the south. This is an indication of its safe-haven status as central banks worldwide start to diversify their reserves away from US dollars and Euros into Aussie dollars.
The IMF recently announced that they intend to make the Australian dollar and Canadian dollar Global Reserve Currencies. Both will be included in the COFER (Currency Composition of Official Foreign Exchange Reserves) surveys, which currently consists of the:
The IMF is asking member countries from next year to include the Australian and Canadian dollar in statistics supplied by reserve-holding nations on the make-up of their central banks’ foreign exchange reserves. In previous years the world has had just two reserve currencies:
1. Sterling up to 1914
2. US dollar since the WWI
Notice the drop in the Australian dollar during the start of the financial crisis but its strengthening since 2009. Australia is just one of only seven countries in the world with a AAA-rating from all three global credit ratings agencies – Moodys, Standard & Poors, and Fitch.
The table below from the Australian Markets Weekly (Published by National Australia Bank) shows the fiscal position of euro-zone and other developed nations. As you can see the PIIGS (Portugal, Ireland, Italy, Greece, Spain) of the euro-zone countries have very high gross debt to GDP levels except for Spain. Japan has the highest but is also the only economy involved in fiscal loosening – see column 4. Notice the severity of tightening in some euro-zone countries as austerity measures start to be implemented. It does seem a little strange that Australia’s tightening in fiscal policy is greater than that of the UK and the US and not that far from the IMF‟s estimate of “austerity” announced for Italy.
The memo items are also of interest in that they show the nominal GDP, debt and budget balance in $USbn. In nominal GDP you have USA, China, Japan, Germany as the leading economies by output levels. China overtook Japan this year.
With continued global weakness the RBA is becoming increasingly worried about the prospects for the Australian economy. According to the National Bank of Australia there are 3 factors that the RBA are concerned with:
1. Although house prices are stabilising there are some sectors of the economy that remain in a depressed state – residential construction has a record low capacity utilisation (see graph).
2. A tightening of state and federal fiscal policy has meant that there is less aggregate demand in the economy.
3. The high value of the AUS$ affects the competitiveness of exports. However business now see the high AUS$ as permanent rather than cyclical. This is important as the RBA is not expecting lower rates to significantly lower the AUS$ but rather is trying to offset some of the economic damage to the economy.
It could be that a rate cut by the RBA is an insurance policy in an environment where inflation appears stable. The graph below looks at the RBA Cash Rate and the Taylor Rule.
The Taylor Rule
This is a specific policy rule for fixing interest rates proposed by the Stanford University economist John Taylor. Taylor argued that when:
Real Gross Domestic Product (GDP) = Potential Gross Domestic Product and
Inflation = its target rate of 2%,
then the Federal Funds Rate (FFR) should be 4% (that is a 2% real interest rate).
If the real GDP rises 1% above potential GDP, then the FFR should be raised by 0.5%.
If inflation rises 1% above its target rate of 2%, then the FFR should be raised by 0.5%.
This rule has been suggested as one that could be adopted by other central banks – ECB, Bank of England, etc for setting official cash rates. However, the rule does embody an arbitrary 2% inflation target rather than, say 3% or 4%, and it may need to be amended to embody alternative inflation targets at different times or by different central banks. The advantages of having such as explicit interest rate rule is that its very transparency can create better conditions for business decisions and can help shape business people’s and consumers’ expectations. Central banks prefer to maintain an air of intelligent discretion over the conduct of their policies than to follow rules, but to some extent they do unwittingly follow a Taylor rule. This makes the rule a useful benchmark against which actual policies can be judged.
For many years China has been trying to guarantee resources for its growing economy. The FT in London recently looked at the Chinese mining company Citic Pacific which has invested huge funds into the Sino Iron mine in Western Australia. Originally hatched in 2006 the level of expenditure has gone significantly higher than expected – from US$2bn to US$7.1bn today. However some have suggested that a US$10bn will ultimately be the cost and this is especially prevalent in that they are two years behind schedule.
It seems that Citic Pacific have put down too much money to pull out – barriers to exit. China imports about 60% of its iron ore and the Sino Iron mine is an attempt by the Chinese to break away from the dependency of foreign suppliers, which Chinese steelmakers accuse of driving prices too high. However Chinese companies have found it difficult to adjust to the foreign working conditions compared to the protected environment in China. Chinese enterprises are often unprepared for the rigours of foreign competitors especially with regard to employment laws and the nature of contracts. China’s mining plans involve the use of Chinese labour as they are cheaper and have a higher productivity. However, overseas labour laws and visa requirements make the use of Chinese labour all but impossible. In Australia truck drivers can earn US$2000,000 a year with three-home housing, free home leave. By seeking control negotiations can become confrontational.
The Chinese were desperate for iron ore when the demand for steel was very high. However Chinese developers realise now that the demand for steel has dropped and prices have fallen. In 2010 China imported less iron ore than the previous year and by 2011, higher interest rates and strict restrictions on property and construction continued to put downward pressure on steel prices. Also for Citic Pacific miscalculations over currency have played a role in increasing costs. The AUS$ has appreciated over the life of the project and controversial hedges that Citic bought went wrong causing a $2bn loss.
Yesterday official GDP figures out of China showed that growth has slowed to 7.6% for the second quarter. This was predicted but as building and infrastructure development accounts for 55% of China’s GDP growth this has a significant impact on demand for iron ore which is a key ingredient in steel.
Further to Jim O’Neill’s talk at the Tutor2u conference one wonders how the Chinese economy is going to land over the next few months. According to the National Australia Bank most believe it is going to be a soft landing given that:
1. The slowdown is desired
2. Policy makers are looking at an expansionary policy to ease the fall
3. Policymakers have a lot of ammunition left to stimulate growth – currently high interest rates (which can be cut) and large surpluses.
Australia’s links with China
The National Australia Bank’s markets weekly looked at the how Australia and China have been closely linked over the last 10 years. They have come up with the following:
Australia is joined to the hip (see graph – Australian GDP Growth – Correlations
Rolling correlations of real quarterly growth) with China given they are its largest export destination. China growing at 8% or 7.5% is probably inconsequential and to materially change the direction of the Australian economy China would need to land so hard that commodity prices would fall sufficiently to turn off many of the big resource projects that are underway. It is naive to think that a recession in China will bring a similar scenario in Australia.
In a small open economy like Australia, the floating $A exchange rate is arguably the most important macro stabilising tool – more so than interest rates. So a Chinese hard landing should mean lower commodity prices and a much lower $A which in turn would help promote growth in some sectors (like tourism) just as the high exchange rate is now curbing these sectors.
The Chinese authorities have cut interest rates for the time since the Global Financial Crisis (GFC). One year lending and deposit rates were cut by 0.25%.
Lending rate – 6.31%
Deposit rate – 3.25%
Although this should encourage spending with an increase in the money velocity in the circular flow some commentators are concerned that the Chinese authorities know something about their economy that the rest of world is in the dark about.
It is interesting to see the reaction of main central banks in the aftermath of the GFC and how aggressive they were in cutting rates – US, EU, UK – relative to the other countries on the graph, namely China, India and Australia. Furthermore notice that some economies seem to have been at a different part of the economic cycle namely Australia, India, and the EU as their central bank rates have risen in order to slow the economy down. This is especially in India as they have had strong contractionary measures in place but have now started to ease off on the cost of borrowing.
Indian growth has slowed to 5.3% this year and although this seems very healthy it is the lowest level in 7 years. A developing nation like this needs higher levels of growth to create the jobs for their vast working age population and without employment there could be a situation not unliike that of Spain where over 50% of those under 25 don’t have a job. The main cause of the slowdown seems to be from a lack of private investment.
Also look how low rates are in the US, UK, and EU. With little growth in these economies the policy instrument of lower interest rates has been ineffective and they are in a liquidity trap. Increases or decreases in the supply of money do not affect interest rates, as all wealth-holders believe interest rates have reached the floor. All increases in money supply are simply taken up in idle balances. Since interest rates do not alter, the level of expenditure in the economy is not affected. Hence, monetary policy in this situation is ineffective.
Last week the Reserve Bank of Australia cut interest rates by 50 basis points. They cut rates from 4.25 per cent to 3.75 per cent – the biggest move since the peak of the global financial crisis in early 2009. This is a rather large cut by international standards as increases and decreases in the rates of central banks worldwide tend to be 25 basis points. However the RBA is worried about the lack of impact on domestic demand and confidence that cuts had last year. Therefore they felt that a more significant cut was warranted to stimulate more growth in the economy.
Also the RBA are worried about the strength of the AUS$ and the impact it is having on manufacturing and service exports. Although the mining sector is going along quite nicely there is concern about the domestic service and non-mining sectors as investment has been quite weak. Other data has showed that house prices have fallen 1.1% in the first quarter of 2012 and that lending rates have risen 0.1% and the cut in the cash rate will probably not be passed on to those borrowing.
Although some say that the RBA might be ‘behind the play’ you do have to remember that in Australia (unlike NZ and other economies) they don’t have monthly CPI figures but quarterly. Therefore they have to wait for a quarterly result to have any idea of where inflation is heading.
The world economy still struggles to release itself from the shackles of recession. The US economy has had only a very small increase in growth and European economies still struggle with the sovereign debt issue. However, Australia continues to grow, largely as a result of the strong demand for its commodities from the number two economy in the world, China (see graph for Australian export destinations).
In the October 2010 edition of econoMAX (online magazine of Tutor2u) I discussed the boom in the Australian economy and the challenges that lay ahead – bottlenecks in the labour market and a need for huge investment in ageing infrastructure, and a widening of income disparities between states and sectors in the so-called two-speed economy. But what would be the impact on the Australian economy if China started to contract and their growth levels slowed? How dependent is Australia on China’s insatiable demand for commodities?
A recent IMF paper simulated the impact of a Chinese economic downturn and looked at three
1 A change in the export-led economy to one that more domestic consumption based;
2 A temporary slowdown caused by an over-inflated property market or financial distress;
3 A recession in leading developed countries
Although the Australian economy will be affected by a downturn in the Chinese economy it does have the policy instruments (monetary and fiscal policy) available to be able to stimulate growth and return the economy to the positive slope of the business cycle.
The above is a brief extract from an article published in this month’s econoMAX – click below to subscribe to econoMAX the online magazine of Tutor2u. Each month there are 8 articles of around 600 words on current economic issues.
I have mentioned the ‘resource curse’ in many postings since starting this blog. It affects economies with a lot of natural resources – energy and minerals. The curse comes in two forms:
1. With high revenues from the sale of a resource, governments try and seek to control the assets and use the money to maintain a political monopoly.
2. This is where you find that from the sale of your important natural resource there is greater demand for your currency which in turn pushes up its value. This makes other exports less competitive so that when the natural resource runs out the economy has no other good/service to fall back on.
In 1995 Jeff Sachs, then a Harvard Professor, co-authored a paper with Andrew Warner in which they stated that countries with a higher proportion of resource exports had experienced a slower rate of economic growth. However, The Economist recently noted the research of two Swiss-based economists which draws different conclusions. They basically say that it is crucial to distinguish between the following:
Abundance – having lots of resources
Dependence – having a high proportion of exports in resource-related industries.
They found that greater resource abundance leads to better political institutions and more rapid growth. Those with poor political institutions – Zaire, Nigeria etc – are unlikely to develop other sectors of the economy to reduce dependency on natural resources. The chart below from The Economist shows that the recent growth of OECD countries that are energy exporters against other members that are neutral or oil importers. Although they have grown more over the years with an increasing oil price, their strengthening currency hasn’t affected their economy’s that much. The key test is when the resource runs out – have countries reinvested in areas that they can fall back on or has this investment gone into the energy industry itself. For the Aussies this is very important especially if China has a hard landing. Time will tell.
With the stagnating growth levels in the developed world – USA, Europe, etc – the emerging economies are not immune from this environment. Lower export demand for goods and services impacts on average growth levels in those emerging countries. In order to get out this sluggish condition economies can employ both monetary and fiscal policy. However richer nations have tended to exhaust both these policy options by dropping interest rates to exteremely low levels (see interest rates below) and in their inability to exapand their borrowing because of the size of governmets deficits. Emerging economies average budget deficit 2% of GDP, against 8% in the G7 economies. And their general-government debt amounts on average to only 36% of GDP, compared with 119% of GDP in the rich world.
The Economist ranked 27 emerging economies according to their ability to utilise expansionary fiscal and monetary policy. They used 6 indicators to assess a country’s ability to use these policies. The first 1-5 focus on the ease of which countries can manipulate monetary policy interest rates. 6 concerns Fiscal Policy flexibility
1. Inflation – 2% in Taiwan to 20% or more in Argentina and Venezuela.
2. Excess Credit – measures the gap growth rate in bank credit and nominal GDP. Argentina, Brazil, Hong Kong and Turkey have seen credit grow vastly beyond GDP whilst Chinese bank lending is now rising mor slowly than GDP.
3. Real Interest Rates (interest rate – CPI) – tends to be negative in most economies. Over 2% in Brazil and China
4. Currency Movements (against US$ since mid-2011) – Nine countries, including Brazil, Hungary, India and Poland, have seen double-digit depreciations, with the risk that higher import prices could push up inflation.
5. Current-Account Balance – If global financial conditions tighten, it would be harder to finance a large current-account deficit, and so harder to cut interest rates.
6. Fiscal-Flexibility Index – combining government debt and the structural (ie, cyclically adjusted) budget deficit as a percentage of GDP.
From The Economist
The average of these monetary and fiscal measures produces our overall “wiggle-room index”. Countries are coloured in the chart according to our assessment of their ability to ease: “green” means it is safe to let out the throttle; “red” means the brakes need to stay on. The index offers a rough ranking of which economies are best placed to withstand another global downturn. It suggests that China, Indonesia and Saudi Arabia have the greatest capacity to use monetary and fiscal policies to support growth. Chile, Peru, Russia, Singapore and South Korea also get the green light.
At the other extreme, Egypt, India and Poland have the least room for a stimulus. Argentina, Brazil, Hungary, Turkey, Pakistan and Vietnam are also in the red zone. Unfortunately, this suggests a mismatch. Some of the really big economies where growth has slowed quite sharply, such as Brazil and India, have less monetary and fiscal firepower than China, say, which has less urgent need to bolster growth. India’s Achilles heel is an overly lax fiscal policy and an uncomfortably high rate of inflation. The Reserve Bank of India has sensibly not yet reduced interest rates despite a weakening economy. In contrast, Brazil’s central bank has ignored the red light and reduced interest rates four times since last August. In its latest move on January 18th, the bank signalled more cuts ahead. That will support growth this year but at the risk of reigniting inflation in 2013. Desirable as it is to keep moving, ignoring red lights is risky.
“Toyota Australia is facing severe operating conditions resulting in unsustainable financial returns due to factors including the strong Australian currency, reduced cost competitiveness and volume decline, especially in export markets,” Toyota spokesman
This is the first sign of the resource curse that has plagued so many resource-rich countries. 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.
Aussie minerals are a potential ‘curse’ as it is mainly dependent on the Chinese economy. So what can the Austalian government do to minimise the impact of the resource curse?
1. Like Norway, it could put export revenues into Sovereign Wealth Funds (SWF).
2. Greater subsidies into non-commodity industries
3. With greater income from commodity industries it should develop domestic demand when international demand is subdued.
4. Investment in infrastructure and training/education is essential so that the entrepreneurial environment is vibrant. Avoid inertia and use the good times to plan ahead
5. Be prudent with borrowing and avoid exposure to debt because commodity prices might be high. Just like the sub-prime crisis – using your property as security.
They might be beating India at cricket but the economy is showing the first signs of the dreaded Dutch Disease – DDD.
Yesterday the RBA cut its key cash rate for the first time since 7th April 2009 – the last rates move was exactly a year ago (2nd November 2010) when rates went up by 0.25% to 4.75%. The cut amounted to 0.25% which leaves the key rate at 4.5% – a very high rate by international standards. The graph below shows that the US, Euro zone, and Japan have engaged in an aggressive expansionary monetary policy by lowering interest rates. Whilst Australia has experienced higher interest rates as its economy has grown at rate which has put pressure on its productive capacity and ultimately inflation.
Typically the RBA has cut or increased interest rates over a long period of time so are further cuts to follow? Sydney Morning Hearld economics correspondent Peter Martin likened these series of cuts/increases to cockroaches – there is never one of them. However he believes that this cut is a one-off and that the RBA has reached its neutral interest rate – that rate which is neither expansion or contractionary to the Australian economy. Here is the last paragraph of RBA Glenn Stevens’ statement:
Over the past year, the Board has maintained a mildly restrictive stance of monetary policy, in view of its concerns about inflation. With overall growth moderate, inflation now likely to be close to target and confidence subdued outside the resources sector, the Board concluded that a more neutral stance of monetary policy would now be consistent with achieving sustainable growth and 2–3 per cent inflation over time.
With the downgrade of the at the end of September the NZD/USD will remain volatile and the BNZ reckon that the price range for the NZ$ will remain between 0.7608-0.8573.
Standard & Poors – long-term foreign-currency credit rating – from AA+ to AA
Fitch – long-term foreign-currency credit rating – from AA+ to AA
Mooody’s – long-term foreign-currency credit rating – remains at Aaa
What is affecting the NZ$?
* concerns about European Sovereign Debt
* Decline in dairy prices – although a weaker NZ$ against the US$ can actually increase prices in NZ$ terms (milk powder is traded in US$).
* Investors now moving to the safe haven of US Treasuries – Treasury securities are the debt financing instruments of the United States Federal government, and they are often referred to simply as Treasuries. There are few alternative safe-haven assets out there that can match the depth and liquidity of the Treasury market
However with still relatively higher interest rates than most other developed nations (see table) there is the chance that the NZ$ will appreciate. Today the Reserve Bank of Australia (RBA) held its target cash rate at 4.75% as current global economic conditions have put the brakes on growth and inflation.
I came across a very useful presentation by Prof. Bob Buckle (University of Victoria, Wellington) which focused on the Chinese economy and its implications for New Zealand. It looked at how China has remerged as global powerhouse and identified certain reforms that brought about this change:
1. Deregulation of markets with the introduction of export processing zones (EPZ) which ultimately attracted foreign direct investment (FDI).
2. In 1979 the then US President Jimmy Carter signed the MFN Agreement – Most Favoured Nation. It provided trade equality by ensuring that the importing country will not discriminate against the other country’s goods in favour of those from a third.
3. Reform of State Owned Enterprises which were extremely inefficient
4. Socialism with Chinese characteristics – The Chinese decided to keep the political system of communism but get rid of the economic system of communism and move towards Market Socialism. With that they could keep their political control but also have the benefits of the market place.
The implications for New Zealand of the growth of China include:
- China’s share of NZ trade risen dramatically and will continue to do so – affect of free trade agreement in 2008.
- Now NZ’s second largest trading partner after Australia.
- China’s investment in NZ industries is still relatively insignificant.
- Raised NZ’s terms of trade and net national income.
- Is China becoming the new 19th century Great Britain for NZ (and Australia)?
Here is a graphic from The Economist. Interesting to note that we still have the highest number of sheep per member of the population at 7.5. Also, although not on the graph, NZ has the second highest number of cows per person coming in at 2.3 with Urugauy taking the podium with 3.7 per person. Other statistics include:
- there are 19 billion chickens on the planet – 3 per person
- China has the highest number of chickens, sheep, and Pigs – the latter being very popular
- as you might expect most of the livestock is from the developing world
The 2011 March quarter GDP figures were quite amazing when you think of the tragic earthquake in the Christchurch area last February. The economy grew 0.8% (0.4% forecast) which signifies that the economy outside of Christchurch is very strong. If you compare the data from the other recent natural disasters, being the Queensland floods and the Tohoku earthquake/tsunami, New Zealand has actually grown – see figures and graph below:
* Australia had a 1.2% drop
* Japan had a 0.9% drop
The NZ$ and QE3
Also the NZ$ keeps motoring ahead – yesterday reaching US$0.85. However, with the official cash rate at 2.5% one wonders what is the currency reacting to? Most likely it was:
*the better than expected Q1 GDP figures outlined above and
*the words of US Fed Chairman Ben Bernanke who strongly suggested the US economy was in need of some more serious antibiotics in the guise of QE3 – Quantitative Easing 3 in which the Fed bascially print money.
Bernanke indicated that QE3 would depend on two conditions, economic weakness beyond current expectations, and a renewed threat of deflation.
The Fed is charged by Congress with minimizing unemployment, and some of its critics say that current unemployment rate of 9.2 percent should be a sufficient reason by itself for the central bank to expand its roster of economic aid programs.
Mr. Bernanke noted that the scale of the Fed’s existing efforts was unprecedented. The central bank has kept short-term interest rates near zero for more than two years. It also owns more than $2 trillion in mortgage-backed securities and government debt, the legacy of its two asset-purchase programs to reduce long-term interest rates.
New York Times
Future worry for NZ economy
These figures indicate strong underlying growth in the NZ economy but there are concerns about capacity contraints if the economy is to grow more. And if this is the case there will be significant pressure on prices and a sooner than predicted OCR increase by the RBNZ.
I am off on holiday for a week and will resume service on Monday 25th July.
The Australian Bureau of Agricultural and Resource Economics and Sciences (ABARES) recently published its April report on – “Minerals and energy: major development projects – April 2011 Listing”. It is quite staggering the amount of investment being put into this sector of the Australian economy. At the end of April 2011, there were 94 projects at an advanced stage of development, with a record capital expenditure of $173.5 billion. Below is the breakdown by state and notice the dominance of Western Australia.
In 2010–11, exploration expenditure in Australia’s minerals and energy sector is estimated to be $5.9 billion, broadly similar to expenditure in 2009–10. Investment in mineral exploration remains strong, with Australia expected to record its third highest annual mineral exploration expenditure in 2010–11. Click on the image below to see the ‘Advanced Minerals and Energy Projects’ currently in operation – no wonder they can’t find any workers in the cities.
The Economist last week had an article entitled “Australia the next Golden State” in which they suggested that the country with its booming economy could become the new California.
It already has a successful economy, which unlike California’s has avoided recession since 1991, and a political system that generally serves it well. It is benefiting from a resources bonanza that brings it quantities of money for doing no more than scraping up minerals and shipping them to Asia. It is the most pleasant rich country to live in, reports a survey this week by the OECD. And, since Asia’s appetite for iron ore, coal, natural gas and mutton shows no signs of abating, the bonanza seems set to continue for a while, even if it is downgraded to some lesser form of boom.
And they conclude by saying:
Though the country’s best-known building is an opera house, for example, the arts have yet to receive as much official patronage as they deserve. However, the most useful policy to pursue would be education, especially tertiary education. Australia’s universities, like its wine, are decent and dependable, but seldom excellent. Yet educated workers are essential for an economy competitive in services as well as minerals. First, however, Aussies need a bit more self-belief. After that perhaps will come the zest and confidence of an Antipodean California.