The Implications of Falling Commodity PricesThe Implications of Falling Commodity Prices for the...
Transcript of The Implications of Falling Commodity PricesThe Implications of Falling Commodity Prices for the...
The Implications of Falling Commodity Prices for the Australian Economy
Scott Brian TilburyThe University of New England
FIRST PRIZE
RBA/ESA Economics Competition 2015
The Economic Society of Australia Incorporated
Central Council
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The growth in foreign demand for key Australian exports has created a surge in
our terms of trade that is, both in magnitude and duration, without precedent in
our economic history. This has been a primary impetus for consistent economic
growth, rising real incomes and strong currency appreciation. However, with the
onset of lower commodity prices, Australia can no longer rely on the resources
sector to sustain future economic growth. The onus for policy-‐makers is to
improve the productivity and competitiveness of our non-‐mining industries,
whilst averting economic stagnation.
The dramatic rise in the commodity price index since 2002 (Figure 1) reflects
growing demand from emerging economies for base metals, energy and
agricultural products. In particular, the rapid industrialisation and urbanisation
of China has generated substantial demand for bulk commodities, with export
prices for iron ore and metallurgical coal peaking at more than 600 per cent
above their 2002 levels (Robson, 2015, p. 307).
However, the commodity prices that have hitherto underpinned Australia’s
favourable terms of trade have fallen sharply from their 2011 peaks (Figure 2),
and will probably trend lower as China’s economic growth moderates
concurrently with expanding global supply. Burgeoning commodity prices
precipitated a sustained reallocation of labour and capital into mining and
mining-‐related industries (Connolly & Orsmond, 2011, p. 32). However, this
structural shift is set to reverse as commodity prices trend lower.
For our mining sector, the capital stock is well developed. The capital-‐intensity
of resource extraction, and an initial shortfall in productive capacity, triggered a
large and sustained inflow of foreign and domestic capital. Mining investment
has far exceeded any other sector of the economy (Figure 3), rising from 2 per
cent to over 8 per cent of GDP in 2013 (Garnaut, 2013, p. 90). However, lower
commodity prices reduce the incentive for capital and exploration expenditure,
and the incidence of new resource projects has declined considerably
(Department of Industry & Science, 2015, p. 9).
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Thus, the defining characteristic of the production phase will be a substantial
increase in output from existing assets, particularly for iron ore and liquefied
natural gas (Bishop et al. 2013, p. 47). Although considerable uncertainty exists
over future price movements, the forecast expansion in production volumes may
not be sufficient to sustain long-‐term revenue growth in most markets (Figure
4). Export earnings for the resource and energy sectors declined by 11 per cent
year-‐on-‐year for 2014-‐15 (Department of Industry & Science, 2015, p. 7).
Furthermore, the domestic impact of increased production will be more muted
relative to the investment phase, as the mining industry is largely foreign-‐owned,
and the majority of income is repatriated overseas (Sheehan & Gregory, 2013, p.
129).
A sustained deterioration in commodity prices will precipitate some industry
rationalisation, due in part to over-‐capitalisation during the boom. There is
evidence that this is already occurring, both domestically and abroad, as the
profitability of low-‐grade and high-‐cost producers is increasingly impaired. For
example, junior miners of iron ore are considered unsustainable at current
prices (Saunders, 2015). Additionally, the production phase is less labour-‐
intensive and mining sector employment will fall as large-‐scale resource
investment subsides (Figures 5-‐6) (Bishop et al. 2013, p. 45).
The commodity price boom greatly amplified economic output in certain
industries proximate to mining such as construction, transport, utilities and
business services (Figure 7). By 2011, mining-‐related activity represented
around 9 per cent of GDP (Gruen, 2011, p. 14). However, these industries are
typically comprised of firms that are disproportionately reliant on mining
contracts and are correspondingly vulnerable to any mining sector contraction.
A major corollary of the mining boom has been a sustained appreciation of the
Australian dollar in trade-‐weighted terms (Figure 8). The real exchange rate has
strengthened in conjunction with our terms of trade (Figure 9), as higher export
prices relative to import prices stimulate foreign demand for our currency. The
ensuing rise in net exports has been augmented with large net capital inflows to
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support mining sector investment, pushing the Australian dollar to its highest
levels since Federation (Garnaut, 2014, p. 308).
This has had important ramifications for trade-‐exposed sectors of the economy,
including mining. A higher real exchange rate makes our export-‐oriented and
import-‐competing firms less competitive because domestic goods and services
become more expensive relative to their foreign counterparts (Banks, 2011, p.
2). The mining boom has also generated competition for capital and labour,
which increases domestic costs of production (Bishop et al. 2013, p. 39). These
factors can precipitate a structural decline in trade-‐exposed industries outside
the booming sector -‐ a phenomenon known as ‘Dutch disease’ (Corden, 2012, p.
290). Australia’s mining boom has particularly affected output and employment
in manufacturing and agriculture (Figure 7), although this merely reinforces a
trend that has been apparent since the 1970s (Banks, 2011, p. 4).
Importantly, any tendency towards ‘Dutch disease’ weakens as commodity
prices fall. Lower mining investment facilitates the movement of labour into
non-‐mining sectors of the economy, easing wage growth (Plumb et al. 2013, p.
11). A lower real exchange rate shifts foreign and domestic demand towards
domestic goods, making our export-‐oriented industries more competitive
(Blanchard & Sheen, 2013, p. 435). Price-‐sensitive exports such as tourism,
education, agriculture and high-‐value manufacturing are all net beneficiaries
with a weaker Australian Dollar. For example, every 1 US cent depreciation of
our currency in nominal terms yields a net increase to farming incomes of
approximately $320 million (ABARES, 2015, p. 35).
The long-‐term prospects for our trade-‐exposed industries are encouraging, as
continued development and rising incomes in Asia will sustain demand for a
broad range of Australian tradables (Plumb et al. 2013, p. 39). In particular, the
services sector, which comprises nearly 80 per cent of Australia’s GDP (Banks,
2011, p. 5), is well placed to benefit from the anticipated shift in Chinese
consumption towards services (Plumb et al. 2013, p. 41).
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However, any recovery in non-‐mining sectors will be partly hampered by
investment lags and hysteresis effects (Sheehan & Gregory, 2013, p. 133). Non-‐
mining business investment has slowed in recent years and remains at historical
lows as a share of GDP (Atkin et al. 2014, p. 57). The deterioration in our terms
of trade and a weakening exchange rate will cause real per-‐capita incomes to fall.
Any subsequent weakness in consumption will have a multiplying effect on
aggregate demand, reinforcing the contractionary effects of lower aggregate
investment. If Australia’s economic output stagnates, non-‐tradable sectors such
as as health and retail will be proportionally more affected.
Australia can no longer rely on resource exports for its future prosperity. Policy-‐
makers must support the structural adjustment away from mining activities,
whilst negotiating an impending output gap. In this context, Australia’s existing
framework of interest-‐rate setting to target inflation and support full-‐
employment continues to be appropriate. It is important to note that the
principal mechanisms for achieving a smooth economic adjustment to the terms-‐
of-‐trade shock occur somewhat autonomously, given our institutional settings.
Our flexible exchange rate regime has allowed the strong foreign demand for
domestic goods to manifest primarily through currency appreciation rather than
an inflationary episode (Battellino, 2010, p. 67). As the mining boom wanes, the
depreciation of the Australian dollar will encourage foreign demand for non-‐
mining exports, which will help support economic growth and provide a more
balanced structure to the economy.
Australia’s relatively de-‐centralised wage-‐setting arrangements have ensured
that wage growth in the mining sector has not overly affected other sectors of
the labour market (Gruen, 2011, p. 9). This has curbed inflationary pressure and
will assist the more fluid reallocation of labour to other sectors of the economy
as the mining boom unwinds.
The key challenge now facing policy-‐makers is the manner in which full-‐
employment output can be achieved, without compromising the ability of
monetary and fiscal policy to respond to future economic shocks. Monetary
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policy is the more useful instrument to this end. In the short-‐term, policy
settings must be consistent with achieving a sustained real exchange rate
depreciation to support trade-‐exposed sectors and provide a more balanced
profile for economic growth.
According to the Mundell-‐Fleming model, expansionary monetary policy under a
flexible exchange rate regime leads unambiguously to a depreciation of the
domestic currency and an improvement in the trade balance (Appleyard & Field,
2014, p. 675). A lower interest rate stimulates investment and economic output,
which initially increases imports, creating an incipient deficit in the balance of
payments. This is reinforced by an outflow of short-‐term capital due to interest
rate parity effects, causing the exchange rate to depreciate. The depreciation
leads to an increase in net exports, with the current account effects ultimately
complementing the initial monetary stimulus (Appleyard & Field, 2014, p. 676).
Thus, as commodity prices weaken, the Reserve Bank of Australia (RBA) can
support income and employment in the short term with monetary expansion,
which will place further downward pressure on the exchange rate. This will
support the recovery of trade-‐exposed sectors; with the trade balance in a
stronger position than if expansion is achieved through the budget alone
(Garnaut, 2013, p. 98). Furthermore, reducing our exposure to foreign debt
helps redistribute real incomes and consumption from current to future
generations (Garnaut, 2013, p. 100).
However, an over-‐reliance on expansionary monetary policy also presents
systemic risks. Inflation is not the immediate concern because inflationary
expectations have remained well anchored (Bishop et al. 2013, p. 39) and
inflationary pressure for both tradables and non-‐tradables remains subdued
(Plumb et al. 2013, p. 11). Rather, it is the likelihood that a further reduction of
150 basis points or more will effectively end the RBA’s ability to use
conventional policy, as Australia would be approaching the zero lower bound
(Sheehan & Gregory, 2013, p. 134). This would compromise Australia’s ability to
respond to future economic shocks.
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Secondly, a prolonged low interest-‐rate environment encourages property
market speculation. Despite a renewed focus on prudential regulation since the
Global Financial Crisis, there is an emerging asset-‐price bubble in Australia’s
major cities that may pose a systemic threat to our banking system.
Given the increasing mobility in international capital markets, the use of fiscal
policy to stimulate output and employment is theoretically far less effective.
Assuming flexible exchange rates and relative mobility in short-‐term capital
markets, the expansionary effect of an increase in government spending is
dampened by foreign sector adjustment (Appleyard & Field, 2014, p. 674). Fiscal
stimulus increases domestic output and places upward pressure on interest
rates for a given money supply. This produces an incipient surplus in the
balance of payments due to net capital inflows, which causes the domestic
currency to appreciate (Mankiw, 2013, p. 363). The stronger exchange rate
reduces net exports, which dampens the impact on economic output and pushes
the current account towards deficit.
Thus, the use of fiscal policy to counteract a shortfall in mining output and
investment is inadvisable. The Mundell-‐Fleming model suggests that fiscal policy
is less effective than monetary policy in achieving short-‐term output and
employment objectives. The exchange rate effects associated with an increase in
government spending will only impede the recovery of our lagging export
industries.
Furthermore, falling tax receipts from the mining sector and an increasingly
precarious budget position reinforce the need for fiscal restraint. Government
spending is projected to exceed 30 per cent of GDP by 2055, with net debt to
approach 60 per cent of GDP under currently legislated policy (Commonwealth
of Australia, 2015, p. 46). Australia can ill afford large budget and current
account deficits in a period of moderating economic growth (Garnaut, 2013, p.
96). Again, the accumulation of debt restricts our ability to respond to future
economic shocks.
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In the long term, policies to achieve per-‐capita income growth must focus on
improving our productivity. The maintenance of flexible and efficient market
institutions allows factors of production to be allocated to their highest value
use, regardless of commodity price movements. Low trade barriers, minimal
industry protection, strong competition regulation and a robust productivity
agenda will ensure our continued international competitiveness (Minifie et al.
2013, p. 46).
In summary, the Australian economy has undergone significant structural
adjustment to increase mining sector output over the last decade, but this
process will reverse as commodity prices trend lower. A real exchange rate
depreciation will assist the recovery of our trade-‐exposed industries and achieve
a more balanced profile for future economic growth. Monetary policy is the
preferred instrument to facilitate this transition and support full-‐employment,
although much of the adjustment process will occur autonomously through
existing institutional settings.
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Figure 1: RBA Index of Commodity Prices
Source: RBA, 2015
Figure 2: Bulk Commodity Prices
Source: RBA, 2015
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Figure 3: Industry Share of Business Investment
Source: RBA, 2015
Figure 4: Production of Key Australian Resource Exports
Iron Ore Liquefied Natural Gas
Thermal Coal Metallurgical Coal
Source: Department of Industry & Science, 2015
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Figure 5: Mining Sector Capital Expenditure
Source: Department of Industry & Science, 2015, p. 9
Figure 6: Total Mining Sector Employment
Source: Department of Industry & Science, 2015, p. 9
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Figure 7: Effects of the Mining Boom on Industry Output
Source: Downes, Hanslow & Tulip, 2014, p. 23
Figure 8: Australia’s Terms of Trade
Source: RBA, 2015
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Figure 9: Australian Dollar Against Trade Weighted Index
Source: RBA, 2015
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