By Erik Norland
The Reserve Bank of Australia (RBA) and the Australian national government have much to be proud of. For the past 28 years, they have presided over one of the longest continuous economic expansions in recorded history (Figure 1). No developed economy has matched this track record over the same period and only a few emerging market nations, like China, can claim to have had longer expansions. What's even more impressive about Australia's expansion is that it occurred in the context of an economy that relies heavily on commodities with extremely volatile prices that saw steep declines in 2008 and again between 2011 and 2016.
Figure 1: 28 Years of Continuous Growth, a Remarkable Accomplishment.
Figure 2: Exports of Seven Commodities Accounted for 12.1% of Australia's GDP in 2017.
Little wonder then that the value of the Australian dollar (AUD) broadly follows and, indeed, insulates the Australian economy against price fluctuations in these commodities (Figure 3). Between 2011 and 2016, the weighted value of these seven commodities (based upon their importance to the Australian economy) fell by 60% in US dollar terms. Over the same period, AUD/USD fell by about 40%, which along with easier RBA monetary policy, helped Australia avoid a recession.
In 2016 and 2017, our Australia-weighted commodity price index rebounded and pulled AUD/USD higher along with it. Since 2018, however, AUD/USD has begun to weaken again even as the weighted average US dollar (USD) price of Australian commodity exports remained broadly stable. The divergence between AUD and commodities since 2018 can be chalked up to the opposite trends in Australian and US monetary policy. While the US Federal Reserve (Fed) steadily raised rates in 2018, the RBA has been cutting rates further (Figure 4). This has probably played a role in temporarily depressing AUD's value versus USD. With the Fed widely expected to begin easing monetary policy on July 31, however, the downside pressure on AUD/USD stemming from the Fed could soon be alleviated.
Despite the RBA and the Fed heading in opposite directions the past four years, looking in the longer term, however, both central banks are in a similar position. The RBA has been cutting rates in the face of a 28-year long expansion. The Fed is almost certainly about to begin cutting rates despite the longest US expansion in history lasting a decade. Why would either central bank be cutting rates so far into an economic expansion? At this stage in the economic cycle, shouldn't both banks be tightening policy?
Figure 3: Commodity Prices Broadly Explains Movements in AUD/USD.
Part of the explanation for why the RBA and the Fed are easing policy in an expansion is because inflation in both nations is quiescent. Australian's CPI came in most recently at 1.3% YoY, a very low level by historical standards. Similarly, US headline inflation for June was at 1.6% and while core inflation was at 2.1% core. While modest rates of inflation are clearly part of the issue, in both Australia and the US, inflation rates have been low for decades. As such, inflation doesn't explain the low level of interest rates on its own.
Another explanation for why both countries have such low levels of interest rates following lengthy expansions boils down to one word: debt. As US public and private debt ratios soared since 1980, the Fed has had to continually lower rates, with the peak of each successive interest rate tightening cycle lower than the previous one (Figure 5). It seems that the only way to support such a high debt burden is with extremely low interest rates.
Figure 5: High Debt Levels Killed the Tightening Cycle
The Bank for International Settlements (BIS) has a relatively shorter data history on Australia, dating back to 2000. Even so, as Australian debt levels soared from 150% of GDP to 240% over the past 20 years, the RBA can no longer even dream of hiking rates back to 7.5% - not even 28 years into an expansion and with a weak currency (Figure 6). If "MTV killed the radio star," high debt levels killed the tightening cycle.
Some may argue that Australia's public debt is extremely low. Indeed, Aussie public debt amounts to just 37% of GDP. Non-financial corporate debt in Australia is 75% of GDP, which is high, but similar to the US (74% of GDP). Australian household debt, however, totals 120% of GDP - much higher than the current 76% household debt/GDP in the US and even higher than the US household debt at the 2008 peak of 98% of GDP. In other words, the RBA is easing policy, not because the Australian government or corporations are having trouble borrowing, but rather to prevent a full-blown crisis in the household sector.
Figure 6: High Debt Burdens are Forcing the RBA to Ease 28 years into an Expansion.
Much like the in US during the period from 1999-2006, Australia's debt-fueled expansion has sent residential property prices soaring. Between 1970 and 1997, the real value of Australia's residential real estate outpaced inflation by 1.6% per year on average. As debt levels soared, between 1997 and 2017, residential real estate values outpaced inflation by 4.8% per year, sending the BIS index of Australian residential real estate soaring from 47 to 123 (Figure 7). Prices stumbled in 2018, putting pressure on the RBA to lower rates, also hurting the AUD.
This doesn't imply that a 2008-style U.S. financial meltdown is on the immediate horizon for Australia. After all, the US real estate bubble didn't pop by itself. The Fed had a hand in it by raising rates 17 times between mid-2004 and mid-2006. By contrast, the RBA is taking the opposite approach, preventively easing policy, apparently in the hopes of stabilizing real estate prices and preventing a rapid decline in the real value of residential property that would impair the value of the banks' collateral on residential mortgages. The RBA has been extraordinarily skilled at managing Australia's economy for the past 28 years and it will have to continue operating with extraordinary skill to see its way out of Australia's twin problems of excessive household debt and high housing prices.
Figure 7: Are RBA Rate Cuts Sustaining a Residential Real Estate Bubble?
While the Fed's imminent rate cuts will probably prove supportive for AUD/USD, its longer-term future is tied to China, the destination for 35% of Australia's exports. If one looks at AUD/USD just for the past decade, one might think that the currency is about the lowest that it has even been. Not so. A longer view shows that AUD/USD's historic range has been extremely broad (Figure 8), ranging from above 1.10 to below 0.50. Its recent level near 0.7 is close to its post-1985 average.
Figure 8: Recent Levels for AUD/USD are not Extremely Low by Historical Standards.
Iron Ore: China is the dominant global buyer of Australia's main export, iron ore, consuming 67% of the world total. The reasons why China consumes so much iron ore is simple. In most countries, a large portion of the steel comes from recycling automobiles, demolished buildings etc. In China, by contrast, up until relatively recently, very few people owned cars. The average life of a car is about 12 years. As China's now large fleet of vehicles ages, they will need less new iron ore and will recycle more. Moreover, while China will continue to build new, steel-intensive infrastructure, it won't likely continue the same pace of investment.
Like Australia and the US, China is also faced with soaring levels of debt (from 125% to 250% of GDP since 2008). Moreover, China's working age population, which expanded by nearly 30% between 1990 and 2018, is set to decline by 5% between now and 2030. The combination of high debt, demographic decline and a slowing rural-to-urban transition is likely to slow China's growth considerably during the 2020s, independent of impacts from the US-China trade war. The tariff dispute is undeniably negative for China's short-term growth but not devastating, probably shaving off a few tenths of one percent from GDP. The problem for China is that high debt burdens are making the country's economy more difficult to stimulate using monetary and fiscal policy, hindering efforts to offset the impact of the trade dispute.
All of this bodes poorly for iron ore. While iron ore prices have soared since 2016, getting a boost recently from problems in Brazil - the second biggest exporter after Australia - the prospects for iron ore are not bright and made worse by the fact that global supply has tripled since 1994 (Figure 9).
Figure 9: Global Iron Ore Supplies have Tripled Since 2008.
Coal: Australia's second most important export is hardly the fuel of the future. While China's iron ore needs are likely to slowly diminish over the next decade, the country is making a concerted effort to jettison coal as quickly as possible. Environmental protection is what economists call a "normal good" -the richer you get, the more you want of it. China is becoming a rich nation and environmental protection has moved to the forefront of the public agenda, hence the crackdown on coal and the rapid move towards alternatives. While its hard to be optimistic about China's coal demand and coal prices, there are other possible markets for Australia's coal, including, most obviously India. Even so, as the price of solar and wind energy continues to fall, battery technology improves, and natural gas becomes more competitive, the idea that coal can sustain Australia's exports seems far-fetched.
Gold: Thankfully for Australia's miners and currency, the yellow metal has a negative correlation with Chinese growth and the US dollar. If China slows and the US dollar becomes a weak currency during the 2020s, gold prices could soar. This might not be enough to offset Australia's other likely problems (reduced demand for coal and iron ore, high levels of household debt and a possible real estate bubble), but gold exports still account for 2.2% of GDP, so higher gold prices could mitigate negative impacts on AUD from other sources.
Natural gas: Coal's decline isn't bad for everyone. Natural gas, along with other alternative energy, is a beneficiary. That said, exporting natural gas out of Australia requires liquefaction, shipping and regassification - an expensive process that may limit natural gas export growth. Also, the boom in US production along with the creation of many additional US export terminals adds a big, low-cost competitor into the market. Overall, the outlook for Aussie natural gas exports is somewhat positive but probably not positive enough to move the dial much on the AUD exchange rate.
Copper and aluminum: China consumes 40-50% of the global supply of these two industrial metals, probably about a third of which is re-exported after having been embedded in finished goods. A slowdown in China won't likely be helpful for base metals. Copper and aluminum supplies have also surged (copper doubled since 1994 - Figure 9 - and aluminum tripled (Figure 10)). While one might hope that India will absorb any slower demand growth from China, its economy is one-fifth the size of China's. In short, its easy to see a glut of industrial metals hitting the global market if China slows considerably during the next decade. That said, if America's expanding budget and trade deficits weaken the dollar, that may at least partially offset any slowing in China and keep a floor under metals and other commodity prices.
Wheat: Wheat prices generally follow the Russian ruble, given that Russia and the Ukraine are now the dominant exporters and appear to set the global marginal cost of production. Russia is in robust fiscal health but depends on commodity exports, which, in turn, depend heavily on Chinese demand. Therefore, Chinese growth indirectly helps to set the global prices of wheat.
Figure 10: Can Aluminum Demand Keep Pace With Surging Global Supply?
Overall, AUD/USD is not by any means near historic lows and could potentially fall further - even much further. The prospects of a Chinese slowdown, potentially lower prices for key commodities such as coal as well as ferrous and base metals, on top of Australia's domestic debt and housing issues, makes for an easy bearish case on AUD/USD. That said, there are mitigating and offsetting factors, including likely Fed easing, the possibility of general dollar weakness in the face of bigger US budget and trade deficits, and of a continued resurgence in gold prices.
Even if Australian debt is too high and if commodity prices do in fact slide, that doesn't necessarily mean the end of Australia's 28-year expansion is nigh. Rather, it more likely means continued easing from the RBA and a weaker AUD, both of which may insulate the Australian economy and extend the expansion even under otherwise unfavorable external and internal conditions.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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