The Lucky Country Faces Hard Times

By Philip Bowring

6 January 2012

The Wall Street Journal Asia

Euro zone chaos, U.S. debt downgrade, Japanese disaster, Chinese doubts, Indian disappointment. Few countries ended 2011 in the good books of commentators, but one does stand out: Australia boasts above-average growth, a strong currency and stable banking system. And with a relatively low trade-to-GDP ratio, it is supposedly less vulnerable to global shocks.

But look a little closer and 2012 may be the year when the gilt comes off the lucky country. Start by seeing what has happened to its major export prices since 2002. Iron ore is priced at $138 a ton today, up from $13 a decade ago, and thermal coal is now $115 a ton compared with $29. Gold is selling for $1,600 an ounce against $280. LNG is currently up only 50% at $120 per thousand cubic feet but has been above $450.

Although 2002 saw the last bottom of the commodity cycle, the gains since then are only sustainable if the business cycle has been repealed. The answer to high prices is high prices.

Coal and iron ore are in abundance around the globe but transporting them required new ports and railways, which are now being built. Copper and gold are less abundant, but with prices now more than double marginal production costs, dozens of new or enlarged projects are in train -- many funded by China, which wants to shift the balance of power from the commodity producer to the consumer. LNG prices have already collapsed and if fracking goes ahead at a fraction of its potential, producers could be waiting a decade or two for a new price boom.

Some of the commodity projects do not come to fruition till 2013 or 2014, but enough are already nearing completion to make an impact much sooner. Look at Japan's Komatsu, a leading maker of mining equipment. It recently reported a 24% rise in sales in 2011 and expects a further 10% growth in 2012 as projects move from the development to the production stage.

The producers' assumption is that additional demand from China will continue to keep prices buoyant. But China's growth is slowing and anyway will move gradually from materials-intensive infrastructure to consumption and services. India and other developing countries should see steady growth but that will probably no more than offset stagnation in developed world demand for materials.

All this should be worrying for Australia, where the consensus believes that any softening in mineral prices will be offset by increases in Australian supply. But in commodity cycles prices always move much more violently than changes in demand. How would Australia's trade look if gold was back at $800, coal and iron ore $60? The 30% gain that Australia has enjoyed in its terms of trade, which has underwritten so much else, would quickly vanish.

Australia is also more export-dependent than the raw trade numbers suggest. That's because almost all its export value-added is at home, while for manufactured-goods exporters like Korea and Taiwan local value-added is far less.

Australians should be doubly concerned because an export price boom bigger than in the 1970s and about equal to that of a century ago has still seen it averaging a current account deficit equivalent to 3% of GDP. Even 2011, with its record mineral prices, will probably see a 2% deficit.

It is often assumed that current account deficits are normal as Australia is a young nation that can put foreign capital to good use. But Australia is not a developing economy anymore, it is an aging developed country. Its accumulated foreign liabilities

now total $848 billion or 60% of GDP, of which $740 billion is net debt. Its bank loans are 40% funded by borrowings of around $300 billion from overseas -- not a comfortable position when global interbank markets are so nervous.

What's more, a high proportion of bank loans are to households with the highest debt-to-income ratios in the developed world thanks mostly to very high housing prices. A very strong Australian dollar -- almost double its level against the U.S. dollar of a decade ago -- has hurt manufacturing and tourism.

For sure there are cushions. The government has little foreign debt; the banks' foreign currency borrowings are hedged; the freely floating currency acts as a shock absorber; there is scope to reduce interest rates; household savings have risen for the past two years; the big mining companies are cash rich and can mostly finance expansion from their own resources. Australia remains a politically safe refuge for Chinese and other new money.

But the bottom line is that Australia is more vulnerable than is usually assumed. Certainly more so -- excluding governance issues -- even than Indonesia, which has a healthier trade balance, much less foreign debt, better demographics and a broader economic base. As for China, a commodity price retreat could more than offset stagnation in western markets and provide a non-inflationary stimulus to domestic demand. What is now good for China is no longer good for Australia.