November, 2013

How will Australia grow?

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How will Australia grow?

Important data released about the Chinese economy in June of this year sent a dismal signal to the Australian economy. Chinese growth was expected to decline after years of extraordinarily high levels. No need to be an expert to know that a decline in Chinese growth would have serious effects on the Australian economy.

Current data shows however that China will continue to grow at a rate of 7.5% to 8% p.a. This quells concerns about the immediate future of Australia’s economy, while exposing the dependence on China in the long term. The question we ask today is if China is taken out of the equation or fails to achieve these expectations, how will Australia grow? Like most economic matters, there is no consensus view on the matter. In this report we look at different avenues for private investment to boost growth after expected decline of the mining investment boom.

Lets begin with the numbers. The latest data on the Australian national accounts released in June shows that the economy has been growing at a measly 2.6% p.a over the past year, a decline from 4.4% p.a as recently as a year ago. The graph below shows the fluctuations in the annual growth rate over the twenty-year period between 1993-2013.

How will Australia grow_ 1

Undoubtedly Australian growth in the last decade has been spurred by the booming resource industry. China has had a huge appetite for mineral ores due to infrastructure spending by the central government. However this demand has fallen, as observed in the Purchasing Managers Index (PMI) shown below.

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PMI indicates the economic health of manufacturing. Figures below 50 represent a contraction in manufacturing. This is clearly evidenced in the graph above. The effect of this falling PMI has resulted in a decline in Australian commodity prices. Shown in the graph below.

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Consequently, it has been suggested that the mining boom has peaked.

Certainly the prospect of a decline in mining is further evidenced in the figure below, which shows the likelihood of project investment in mining into the near future. This graph is shocking in as far as it shows a drastic drop off in investment. With current and likely mining investment sitting just above $250 billion, the projection of significantly less than $50 billion for 2018 will have serious consequences for the Australian economy.

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Westpac's latest quarterly report, Australia's Investment Project Pipeline, confirms this decline: "The value of definite mining projects declined, down 2.3 per cent to $252 billion. This was the first quarterly decline since 2010, and follows a run of ten consecutive gains."

After years of record levels of investment in mining, the real and projected decline in investment is a startling wake up call to Australia. While some suggest this is the signal of the end, others have offered, quite modestly, that this merely indicates a transition away from capital investment in mining. Either way we can understand that the economy is in transition. Whether the transition will be smooth or bumpy is the important factor to think about.

Heading for a recession?

Westpac Chief Economist Chris Caton adamantly argues against the suggestion that Australia is on track for a recession as a consequence of a decline in mining investment. While he acknowledges the circumstances seem challenging there is no inevitability about a decline. He stresses that there is no silver bullet.  Growth will not come from one sector alone. Instead he says growth will need to be stimulated from all sectors that are helped by lower interest rates, a lower exchange rate and an improvement in business sentiment with a Coalition government.

With these conditions all now met the environment is ripe for investment. What we need to see is a more concerted transition of investment into the non-mining sector. But as the current data indicates, this is not occurring.

Non-mining investment is key

Non-mining business investment remains to be in steady decline. The non-mining sector is expanding at an annual rate of just 2% p.a, down from the usual 3% p.a. The latest ABS data shows that the biggest contributors to this growth over the past year, excluding the mining sector, were financial and insurance services at 0.7% and health care and social assistance at 0.3%. Manufacturing, electricity, gas, water and waste services detracted by 0.1%.  Considering that mining accounted for 0.7% of growth indicates the potential import of these industries if more investment shifted towards them.

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Selected Industries Contribution to Growth June 2012 to June 2013

The ABS data from June did not indicate that this shift was happening however. The nominal value of manufacturers’ expected capital expenditure for 2013-2014 is 25% down on the corresponding estimate a year ago. This is significant. It indicates a contraction in expected manufacturing investment when there is a need for expansion to fill the retreat of mining investment. The data also shows that the trend estimate for total new capital expenditure fell 0.7% in the June quarter 2013. But the seasonally adjusted estimate for total new capital expenditure rose 4.0% in the same period. Alan Mitchell from the Financial Review suggested that this data was ‘weakly encouraging’.

What this indicates is that the real inhibitor to growth is lack of investment. But this has to do with a lack of investor confidence. With the decline in mining and contraction in manufacturing, where will growth come from?

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New Capital Expenditure in Volume terms

Mitchell suggests that the potential for a pick up in non-mining business investment must be connected to the services sector, which includes construction, the power and water utilities industries, retail, wholesale, transport, property and professional services. The latest data on unemployment vindicates this position. The only sectors that have not experienced jobs losses over the three month period to August, and in fact have experienced job creation, are construction, public administration and safety, financial and insurance services, electricity, gas, water and waste services, transport, postal and warehousing, and mining. All other sectors have shed jobs. Which does not bode well for the economy at large.

The real source of optimism for Mitchell is the recovery in the housing construction industry. ABS data shows that this sector created 56,000 jobs over the August quarter. Earlier data indicated that the number of finance commitments for owner occupied housing finance rose 0.2% in July 2013, following a rise of 0.4% in June 2013. This is the eighth consecutive rise since December 2012. Shown in the figure below.

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Construction of Dwellings

Compared to the highs of 2009 figures, these increases seem insignificant. Mitchell argues that they should not be underestimated. He identifies that a multiplier effect is already impacting incomes of real estate agents, solicitors as well as transaction taxes– which have risen a significant 18% in the past year. Mitchell suggests that this shows a serious boost to construction is on the way.

The question of course is whether housing construction can be the major driver of growth into the future. Mitchell is both optimistic and realistic on this topic. He suggests that a simple glance over history shows that a construction recovery will spread across manufacturing (wood products, fabricated steel, bricks and glass), which will have an effect on the services sectors of finance, transport, wholesale and retail. Mitchell is not shy in recognizing the impact of construction will not lead to investment across all of these sectors, but identifies that it will lead to some. The latest employment data confirms his perspective.

Conclusion

Australian growth is currently dependent on growth in China. The consequence of a decline in Chinese growth rates will have serious effects on the Australian economy. While there is no consensus view on the inevitability of this, it does create cause for concern. Analysis of current data shows that growth in other sectors in the economy is meager. But there is potential for these industries to have great impact. Investors and policy makers in Australia must consider alternate and importantly long term investment options in the services industries to ensure the maintenance of growth into the future. Certainly, with the news that employment experienced the biggest quarterly loss in almost 13 years, this investment could not come sooner. The newly elected Coalition government must now consider how to make this happen.