Resources bust worse thanks to Howard–Costello
Sometimes, when we’re angry and hurt, we blurt out uncomfortable truths we have long tried not to admit, as Treasurer Joe Hockey did this week.
It was understandable, given the exceedingly narky tone of what Peter Costello had written in the Murdoch media about the government’s plans for tax reform.
The former Liberal treasurer fulminated against suggestions that action might be taken to outlaw some of the tax avoidance practices of multinational corporations, such as Murdoch’s. He complained about proposals to make wealthy superannuants pay something on their large retirement incomes, currently tax-free. He decried the idea that the generous arrangements applying to negative gearing, capital gains tax and share dividends might be tightened.
It was bad enough, Costello suggested, that the Greens, Labor, the Treasury department and “the left-wing think tanks” were suggesting such measures. Worse was the fact that the Liberal government appeared to be considering some of them seriously.
The government’s three-word tax slogan – “lower, simpler, fairer” – looked like “some kind of morbid joke”, Costello wrote.
“Remember, the Abbott government has already increased the top marginal tax rate to its highest level in 25 years. That did nothing for the economy ... It didn’t appease the envy industry. All it did was sharpen their appetite for more tax rises.”
Hockey was stung and replied in kind, saying Costello was entitled to give free advice, but the fact that it was free indicated “what it’s worth”. He pointed out, quite fairly, that he faced a much more difficult economic situation than Costello ever did.
“If I had the same revenue as he had, then I’d be getting $25 billion extra each year to be able to spend on things,” Hockey said.
And there it was, the accidental truth. After 18 months of insisting he was dealing with a “debt and deficit disaster” caused by excessive spending by the previous Labor government, Hockey has finally acknowledged that the current budget crisis is much more about revenue than spending.
But the fact that Hockey and the government are at last conceding – indeed suddenly emphasising – the reality of the situation instead of just playing the politics of it does not make that reality any less scary. It is actually a measure of how dire things have become.
For 15 years or so Australia rode an epic boom in its resource exports. Now we are experiencing an epic bust.
That is not to say Australia’s good fortune has run out permanently. In all likelihood things will get better, given prudent management. But the indications are we’re in for a few tough years.
Commodities prices falling
Our second-biggest commodity export, coal, began the slide. Its price peaked in early 2011, and has since declined pretty steadily to reduce by about 60 per cent. The price of iron ore, our biggest export, held up longer, but its fall was even more spectacular. Only two years ago it was worth about $US150 a tonne. One year ago it was about $114. This week it was under $50.
In an interview on Monday, Hockey said he was prepared for it to fall further, perhaps to as low as $35.
He was talking about a worst-case scenario, but what he was saying was not implausible. The Swiss-based investment bank UBS had just calculated that the minimum break-even price required by Australia’s two big iron ore miners, BHP and Rio Tinto, was $34 a tonne.
The suggestion was the two giants might be prepared to make just $1 a tonne on their resource for some time, to drive other more marginal players out of the glutted iron ore market. Cashed up as they are after years of sky-high prices, they could afford to. Already deep in deficit, and with the prospect of deficit budgets stretching decades into the future, the Australian government has no such luxury.
Even if the ore price does not plumb such depths, market analysts see little prospect of the price increasing much beyond its present level for several years at least. The same is true of coal.
As a result, the government is looking at a $30 billion hole in the budget over the next four years.
No wonder alternative sources of revenue are being canvassed. No wonder Hockey was peeved at the intervention of Costello, whose 11 years as treasurer, it is now increasingly apparent, were marked more by good luck than good management.
The luck began to run out under the former Labor government, not that Hockey or anyone else in the Coalition ever acknowledged that. First there was the global financial crisis, followed by a sharp decline in tax receipts, in part due to burgeoning avoidance by multinational corporations – another reality the current government has only belatedly acknowledged. Then the coal price fell. And then, for a variety of reasons including the softening economy, the government fell.
If there was ever a good election to lose, it was the 2013 election, for since then the economy has gone seriously bad.
China's property market the key
It’s not the fault of the Abbott–Hockey government any more than it was of its Labor predecessor. The simple fact of the matter is that Australia’s long streak of easy prosperity, during which we were given large amounts of money for simply digging stuff out of the ground, has come to an end. You can’t hold our governments accountable for the vagaries of global commodity markets.
Australia’s economic and budgetary problems, like just about everything else these days, were made in China.
And the magnitude of Australia’s economic bust is directly related to the magnitude of China’s boom over the past decade or so. The arithmetic is simple: when the Chinese economy was growing at 10 per cent year on year, and the country was building vast stocks of infrastructure and housing, the demand for steel forced up the prices of coal and iron ore.
“Three years ago,” says Mark Pervan, head of commodity research for ANZ bank, “three-quarters of the industry were seeing 200 per cent margins. They were making stunning profits. And they committed to particularly large expansion plans.”
That’s simple supply and demand. But the problem with mineral commodities, which has always made them strongly cyclical, he says, is that “supply tends to lag demand by two or three years”.
Thus a lot of new supply came online, not only in Australia, but in places such as Indonesia (coal), Brazil (iron) and China itself (coal).
“In iron ore you had the tier one big producers – BHP, Rio, Vale – always operating at much lower cost. Then you had the others coming through who were much higher cost – the Atlas Irons, Mount Gibsons and so on.”
The huge increase in supply would have made things difficult for the higher-cost producers even if demand had remained constant. But it didn’t.
“Everyone’s looking at supply. They should be looking at demand,” says Pervan.
UBS commodities analyst Daniel Morgan agrees.
“The most important thing to watch is the Chinese property market,” he says.
“Around 40 to 50 per cent of steel in China goes into property, and in the last few years there’s been an overbuild of apartments and commercial buildings over there, a huge boom, and now they are saddled with large inventories of semi-finished buildings.
“As a result, demand for steel is lower than people were anticipating, ourselves included, only 12 months or so ago. Chinese steel consumption declined last year. We now think that in 2015 production will go backwards.”
Morgan expects demand to be flat at best for the next five years, and the iron ore price to stay flat, too.
“We’ve moved to $55 a tonne long term,” he says. “And the outlook for coal is probably worse in some ways. China has massive reserves of coal. It only became a net importer in 2008 or 2009, because there was a lot available after the GFC.
“The industry expanded capacity thinking it was a sustainable, ongoing thing. Now, though, Chinese imports are going backwards. They are withdrawing from the trade, so all this capacity is looking for another home elsewhere in the world.”
The big hope of the Australian coal industry is India, but it has massive coal resources of its own. Its problem is constraints on infrastructure, which the country is currently moving to address.
Morgan says: “We used to serve countries that were short on coal: Japan, Korea, Taiwan, reasonably steady markets. Now the industry is pinning its hopes on two large markets which don’t really need our coal, although they might take it at favourable prices.”
The long decline of coal has not struck the public consciousness as hard as the iron ore collapse, but it is having economic effects. The huge deposits in Queensland’s Galilee Basin are looking ever more stranded, despite the continuing assurances of the Indian conglomerate Adani that it will go ahead.
“I don’t buy into a lot of the environmental arguments about the Galilee,” says Morgan. “I just look at the economics. I think that coal isn’t needed. The hurdle of financing will be too great.”
That’s bad news for the debt-laden Sunshine State, but the news is much worse in Western Australia, which is even more resource dependent.
The WA budget for this year was predicated on an average iron ore price of $US122.70 a tonne over 2014-15. Last September the economics editor of The West Australian, Shane Wright, calculated that for every dollar the price fell, the budget position deteriorated $49 million. On that basis, the state was then $1.7 billion down the hole – and that was when the price was still almost $85 a tonne. The figure is now well over $2 billion.
The west’s position is made all the worse because its share of GST revenue, calculated on the basis of its economic position two years ago when the royalties were flooding in, is set to drop to about
30 cents on the dollar this year.
There have been dark rumblings of secession, but it won’t happen because, apart from other practical considerations, the west couldn’t afford to go.
Costello's cuts now biting
Just about every day over the past couple of weeks seems to have brought more grim news. Atlas, a medium-sized iron ore producer, announced it would mothball its mines. Other small miners are heading the same way. The ratings agency Standard and Poor’s announced it was reconsidering the credit ratings of all the miners – and the state of Western Australia to boot. The latest consumer confidence survey showed a decline attributed to worries about the slowing economy. On Wednesday, the latest statistics on the Chinese economy showed it still chugging along, by past standards, at 7 per cent growth.
So perhaps it was inevitable that the government, if not Peter Costello, should begin grappling with the truth about the revenue problem.
It bears mention that most of the areas now spoken of as being in need of reform involve measures introduced by the Howard–Costello government. The halving of the capital gains tax, which has inflated Australia’s property bubble; the tax breaks on superannuation and on share income via dividend imputation, both of which overwhelmingly benefited the rich; the abolition of fuel excise indexation: all were Howard and Costello’s work.
The Australia Institute, one of the “left-wing think tanks” mentioned by Costello in his op-ed piece, quantified the continuing cost of such measures to the federal budget at more than $18 billion a year. When Costello’s boom-time tax cuts – again favouring the top of the income scale – were thrown in, the total was about $55 billion, or $44 billion if the effects of bracket creep (the process by which inflation pushes taxpayers into higher tax brackets) were excluded.
True, the Costello years did see 10 surpluses, and the paying off of the government’s net debt, but given the torrent of revenue coming to government in the boom years, that was not a difficult task. The Organisation for Economic Co-operation and Development, hardly a left-wing think tank, concluded the latter years of the Howard–Costello government saw the most “profligate” spending since World War II.
Too late for a sovereign fund?
Of course, there were alternatives. Norway is a country with an economy composed similarly to Australia’s, although much smaller. Like Australia, about half its exports are commodities – in its case, oil. Like Australia, those revenues are volatile and, like Australia, the country has recently taken a huge hit due to falling prices.
Unlike Australia, though, Norway is not facing a budget crisis. Its government is not contemplating big spending cuts, much less big spending cuts that mostly impact its less well-off citizens.
The reason is that, in the good times, Norway put money away. Its Government Pension Fund is now the world’s biggest sovereign wealth fund, holding some 1 per cent of global stocks, $900 billion of assets. And it has cushioned the country’s economy and its budget through the market slump.
Australia does have a variant of a sovereign wealth fund, the Future Fund set up under Costello in 2006. It now holds assets of about $110 billion, about one-50th, proportionate to population, of Norway’s. But the Future Fund was established for a specific narrow purpose – to provide for unfunded commonwealth superannuation liabilities. It will not provide cushioning for the economy in the years ahead.
Ironically, Abbott and Hockey have lately been talking a lot about the need to “future proof” Australia against economic shocks. But the time for future proofing was in the past, when Australia had the money to put into it.
Professor of economics at the Australian National University, and former member of the board of the Reserve Bank, Warwick McKibbin is a long-time advocate of such a fund in this country.
“I was writing about it back in 2002-03, when I first joined the RBA board,” he says.
He acknowledges the major problem with such a fund is “how you keep the politicians’ hands off it”; that is, how you prevent governments from misusing it to their own short-term ends.
“Norway is the model,” says McKibbin, because its fund is set up with stringent conditions on how much can
be spent in any given year, and how it can be spent.
So why did Australia not follow that model? To some extent, McKibbin suggests, it comes down to psychology.
“Here people convinced themselves this was a permanent boom, whereas in Norway they accepted the resource depletion argument that the oil wouldn’t last forever,” McKibbin says.
“Here Treasury and others argued … it was better for individuals to be given the money to manage themselves than it was for the government to save on their behalf. I disagreed and I still disagree.”
In McKibbin’s view, the boom years were wasted in complacency.
While the world was rapidly changing around us, we figured we “didn’t have to make structural adjustment because we had a big chunk of income handed to us.
“So while we should have been restructuring our economy and moving human capital, and investing in infrastructure to deal with this transformation, we basically spent it. The government gave tax cuts and made spending increases, which required the boom to continue forever.”
McKibbin’s views are largely shared by another of the ANU’s stable of economists, and another former Reserve Bank board member, emeritus professor Bob Gregory, although Gregory emphasises ideology over psychology.
“The Libs were committed to making government smaller. They figured if they didn’t give tax cuts, it would just lead to bigger government and more government spending,” he says.
Gregory considers that Costello “behaved pretty badly and made a number of major mistakes” in pursuit of the ideology of smaller government.
He sold some assets too cheaply. The tax cuts “were way overdone”, and the decisions about the taxation of superannuation were “absolute madness”.
The two economists disagree, however, on the prospects of setting up a genuine sovereign wealth fund now. Gregory thinks that horse has bolted. McKibbin thinks it worth continuing to plan and advocate for one, in case good times return – not that he sees that as being imminent.
Neither man, however, thinks the lucky country is necessarily facing a dire future.
Says Gregory: “I don’t think we’re running out of luck in any long-term sense. In the long run we’ll be pretty good. If China slows a bit, well, there’s Thailand and Cambodia and all those places.
“Equally it’s clear that in the next few years we’ll be running out of luck. But it’s sort of predictable luck. I thought it would have been tougher than it actually has been.”
Other sectors of the economy, many damaged by the high dollar that the mining boom brought, are bouncing back.
The main issue is how fast that happens.
“Tourism turns around pretty quickly, education services probably, too. Other things will take time, and one is never sure how fast that happens,” says Gregory. “When you devalue a lot, as we have, it gives you a break, but it doesn’t translate straight away.”
McKibbin sees a few difficult years, but after that thinks Australia will be well placed to benefit from the growth of the region and the rise of the new global middle class.
“If you look at where the global economy is headed, after the next few years, Australia is in a position where it has great benefits coming from education exports, from tourism, from environmental goods, a whole range of things we’re really good at.
“So the waves of good luck will continue, we just have to make sure we don’t damage our capacity to respond.”
And that’s the big caveat.
“What you really need,” McKibbin says, “is for politicians on both sides to realise that this is a serious situation Australia is facing and there is the potential of not just wasting the gains of the last 15 or 20 years of the boom, but damaging the next 40.”
The short-termism, the oppositionism that has increasingly infected politics, is tremendously frustrating, he says.
“The major parties should realise there is national interest involved here. No tax reform, no climate policy, no energy strategy, no major social adjustment will occur without a bipartisan approach.”
And this, he concedes, is an idealistic and possibly vain hope.
Australia remains a lucky country, but it is always worth returning to the origin of that descriptor. It was the title of Donald Horne’s 1964 book, and the full quote goes:
“Australia is a lucky country run mainly by second-rate people who share its luck. It lives on other people’s ideas, and, although its ordinary people are adaptable, most of its leaders (in all fields) so lack curiosity about the events that surround them that they are often taken by surprise.”
This article was first published in the print edition of The Saturday Paper on Apr 18, 2015 as "Boomtime rats". Subscribe here.