The Banana Republic Revisited?

(An edited version of this with fewer graphs is available at The Conversation)

We took the view in the 1970s – it’s the old cargo cult mentality of Australia that she’ll be right. This is the lucky country, we can dig up another mound of rock and someone will buy it from us, or we can sell a bit of wheat and bit of wool and we will just sort of muddle through … In the 1970s …we became a third world economy selling raw materials and food and we let the sophisticated industrial side fall apart … We must let Australians know truthfully, honestly, earnestly, just what sort of international hole Australia is in. It’s the price of our commodities – they are as bad in real terms since the Depression … If this government cannot get the adjustment, get manufacturing going again and keep moderate wage outcomes and a sensible economic policy, then Australia is basically done for … If in the final analysis Australia is so undisciplined, so disinterested in its salvation and its economic well being, that it doesn’t deal with these fundamental problems … the only thing to do is to slow the growth down to a canter. Once you slow the growth under 3 per cent, unemployment starts to rise … Then you are gone. You are a banana republic.

(Paul Keating speaking on a wall phone in the kitchen of a function centre to radio personality John Laws on 14 May 1986, cited in Richard H. Snape, Lisa Gropp and Tas Luttrell (1998) Australian Trade Policy: 1965-1997, Sydney, Allen & Unwin, pp. 84-5.)

Revisiting Paul Keating's Banana Republic warning should remind us how economic conditions change and how they keep changing: how new 'realities' quickly become replaced by newer 'realities' masquerading as permanent changes.

Resources have been good for Australia, unlike for some other countries where there really has been a resource curse. However, with the end of the boom it is likely that we will revisit some of the earlier concerns about Australia's over-reliance on resources.

Another quote from the Labor government in the early 1990s also seems particularly relevant at the moment.

This tough, increasingly competitive world of five and a half billion people does not owe, and will not give, seventeen million Australians an easy prosperity. The days of our being able to hitch a free ride in a world clamouring, and prepared to pay high prices, for our rural and mineral products, are behind us. From this fact flows everything else. 

(Bob Hawke, Paul Keating and John Button (1991) Building a Competitive Australia, Canberra, AGPS, 12 March, p. 1.1. Emphasis added.)

This sentiment was true for the 1980s and early 1990s, but less so for the 2000s where rising prices for resources and increases in national income provided an easier prosperity than Hawke might have imagined.

In 2000, Keating was still arguing against the resources as saviour view of long-term Australian prosperity:

The global terms of trade will not suddenly flow back in the direction of commodity producers. So even if we wanted to, we can never again rely on export wealth generated by Australian farmers and miners to pay for the preservation of tariff walls to protect our manufacturing and services sectors from competition. 

(Paul Keating (2000) Engagement: Australia Faces the Asia-Pacific, Sydney, Macmillan, p. 280.)

China changed everything. Its voracious appetite for resources pumped up the prices Australia received for its resource exports – particularly coal and iron ore. All the warnings of the past were quickly forgotten as resource wealth became the new reality masquerading as a permanent change.

Increased prices then led to a huge investment boom, which in recent years has been centred around gas. The scale of this boom has been remarkable as a recent report from the Australia's Bureau of Resources and Energy Economics (BREE) shows.

But this investment boom has now peaked and Australia must now find new sources of growth. According to BREE, the "likely scenario" is that

the value of projects currently at the Committed Stage is scheduled to moderate after 2013 as a result of the completion of mega projects currently under construction. In 2014 the stock of committed investment is expected to decrease by $8 billion, and then by a further $63 billion in 2015. From 2017 onwards, the stock of committed investment in the mining sector is projected to revert back to levels comparable to 2007.

While some commentators, including the Reserve Bank Governor, argue that we are now entering the third – export – stage of the boom, it is likely that just as the boom surprised us on the way up, the crash will surprise us on the way down.
Australia will no doubt export more for at least a few years, as recent data shows, but with increased global supply and lower prices, it is likely that we'll start worrying about our dependence on resources once again.

Recent data clearly shows that commodity prices are on the decline, with iron ore and coal prices substantially lower. According to the RBA:

Over the past year, the index has fallen by 8.6 per cent in SDR terms. Much of this fall has been due to declines in the prices of coking coal, iron ore and thermal coal. The index has fallen by 9.9 per cent in Australian dollar terms over the past year.

For an explanation of the RBA's Index of Commodity Prices and recent changes see here.

Base Metal Prices

Base metals include aluminium, copper, lead, nickel and zinc.

Bulk Commodity Prices

Bulk commodities include iron ore and coal (thermal and metallurgical).

The Economist also notes the general fall in a range of commodities in USD terms in recent times.

Australia is a lucky country, but it is also a vulnerable country. Australia's historical vulnerability to declines in international demand for resources are about to re-emerge, which will make economic management a difficult task for a new government. Things have been tough for the Rudd and Gillard governments, but they will be even tougher for an Abbott government. Labor was helped by the investment-led revitalisation of the Chinese economy, but the Coalition will come into office at a time of Chinese economic consolidation and rebalancing and, possibly, economic stagnation.
In the late 1980s when some commentators were eulogising about the end of the industrial revolution and touting the beginning of the information age, Australia appeared to be doomed unless it weaned itself off a reliance on resources. This new reality was superseded by an even newer one - the remarkable rise of the Chinese economy. Not only did Chinese demand increase the price of Australian exports, but it also decreased the price of Australian imports. Manufactured imports became cheaper. Remember that the terms of trade - the average price level of exports in relation to the average price level of imports - is a ratio (or fraction) and so can be affected by both the numerator and the denominator. 

The terms of trade improved remarkably from the early 2000s, it then declined as commodity prices fell in the immediate aftermath of the global economic crisis. To the surprise of many, including myself, it then ascended again to new heights as China embarked on a renewed investment boom, a boom that required many of the things that Australia exports. There can be no denying that Australia has been lucky to be in a position to take advantage of China’s industrialisation and widespread Asian exceptionalism in the face of a slow American recovery and continuing European crisis. Similarly, however, any downturn in China and other Asian economies will now negatively affect Australia.

 

Some More Figures on Commodity Prices

In its May 2012 Statement on Monetary Policy, the RBA included this graph on the price declines of individual commodities.

The analysis of recent developments is less gloomy, although the year-on-year declines are considerable.

The [commodity price] index remains at a historically high level, but is around 9 per cent lower than its peak in mid 2011. In general, commodity prices have been supported by the gradual pick-up in global economic activity since the start of the year, though increases in some prices have been partially retraced over April. Spot prices for iron ore and base metals have all increased, while spot prices for both thermal and coking coal have declined in recent months, largely reflecting increased supply. Australia’s terms of trade are estimated to have declined further in the March quarter, as average export prices for bulk commodities continue to decline gradually from their September 2011 peak.

 What happens to prices will largely depend on Chinese demand and the prognosis on that is generally not a confident one by most commentators.

The RBA discusses Australia's resource exports. In relation to iron ore, the depth of Australia's dependence on China is revealed:

Iron ore is Australia’s most significant export, accounting for around 20 per cent of total export values in 2011. The primary destination of Australia’s iron ore exports is China, which accounted for around 70 per cent of iron ore export volumes in 2011, while Japan and Korea imported most of the remaining 30 per cent. Iron ore volumes grew by 10½ per cent over 2011, which is slightly slower than the average annual pace of growth over the past decade. In early 2011, iron ore export volume fell owing to production disruptions from a higher than average number of cyclones in the north of Western Australia. However, iron ore export volumes recovered strongly over the rest of the year to reach new highs, reflecting expansions in the capacity of mines and rail as well as some improvements in the utilisation of port facilities.

Commodity Prices: Is the Boom Over?

Commodity prices are seemingly heading downwards. After a little rise last month, they have fallen again.Given Australia's dependence on commodity exports, the future direction of prices matters a lot.

The long flat period of prices is a major reason why Australians were gloomy about Australia's future as a lucky country reliant on resources. But pow, along came the boom in prices, which started in late 2003 and which continued almost 'exponentially' until December 2008.

That sudden drop was reversed in August 2009, surprising many pundits (including me) and was built largely on fiscal expansion, particularly in China.

Now the real question is what happens in the next 3-5 years and beyond. Will prices fall rapidly or will continuing growth in China and India keep demand for commodities high. What will be the impact of the massive increase in supply of resources that has taken a long time to come on board, but is now beginning to effect prices.

The real danger is that we have declining demand at the same time as increased supply, which as economics 101 tells us will lead to lower prices.

The following charts and data are from and based on RBA data available here. See also here for explanation.

If the figures are disaggregated we can see that base metal prices have fallen even further. This too matters a lot because base metals are significant export commodities.

 
 Rural commodity prices have also fallen and as you can see are much more variable than base metals.

Our most important exports - iron ore and coal - are included under the category other resources. According to the RBA:

Table 1 shows the current and updated weights for the commodity exports included in the ICP. It also shows implied effective weights for September 2009, which reflect the extent to which the current value of the index already incorporates changes to export prices that have already occurred since 2008/09. With the new weights, the relative importance of ‘other resources’ has increased substantially compared with the weights based on export values in 2001/02. These components, which include metal ores, gold and energy commodities, now account for around 75 per cent of the index, and more than 80 per cent once crude oil is also included. The weight of the rural commodities included in the ICP has declined to around 10 per cent from around 30 per cent in 2001/02, and the weights of the base metals included have also declined. These reductions mainly reflect the more moderate pace of growth in export volumes in rural commodities and base metals compared with other resource commodities since 2001/02, as well as the introduction of crude oil prices into the ICP.

Given these perameters, the final chart is based on the Base Metal and Other Resource prices.

The final graph  is the same as the first for all commodities, but expressed like the next two charts in US$, A$ and SDR (special drawing rights), which is represented by a basket of currencies made up of the euro, Japanese yen, pound sterling, and U.S. dollar. The value of the SDR " is calculated as the sum of specific amounts of the four basket currencies valued in U.S. dollars, on the basis of exchange rates quoted at noon each day in the London market."

As you can see the rise in the value of commodity prices has not been as extensive in Australian dollar terms as it has been on USD and SDR terms because the AUD has risen against the USD (a major component of the SDR).