Will the current account balance derail the miracle economy?

The Australian economy has been in a happy state for much of the past few years. Inflation has been low and the unemployment rate has fallen to levels last seen in the 1970s.  There has been a mixture of good luck and good management – the luck is the strong rise in Australia’s terms of trade and the low levels of global interest rates. Analysts have called Australia “the miracle economy.”  We fear this tag will come to be regarded as just as ironical as Donald Horne’s "lucky country”.

Henry Thornton has warned of the risks run by allowing domestic sources of inflation to rise to over 4 per cent. The effects of this have been temporarily masked by a stronger exchange rate, which has kept overall inflation within the Reserve bank’s target range. We have resolutely opposed the lax monetary policy that created the entirely unnecessary and avoidable housing bubble. We have also been concerned by the use of fiscal policy to impart a stimulus at election-time when the economy has been crying out for restraint.

So far these warnings have been ignored, at least to our knowledge. But Henry now fears for the worst. With fiscal policy targetted on election outcomes and the RBA narrowly interpreting its mandate to target goods and services inflation, there is no one focused on ensuring Australia achieves a tolerable external balance. We think it is time for the RBA to take off its blinkers.

So far Australia has been lucky, as is often the case. No-one has been bothered by the current account deficit, even at its recent 6 per cent of GDP levels.  The economic managers of the "miracle economy" have been distracted by strong global economic growth, fuelled by overheated China and booming America.  India and Russia are growing strongly and south-east Asia performing well.  Even Japan is in strong recovery mode and Euroland is growing. While the good times roll, the so-called "Pitchford thesis", that foreigners would finance any essentially-private-sector-driven deficit, has held true.

Regrettably, it seems to us that failing to achieve reasonable external balance in the period ahead might bring the domestic boom to a halt. The good times do not appear sustainable.

As already noted, Australia has been experiencing a sharp and sustained rise in the terms of trade, the ratio of export prices to import prices (graph 1). The Reserve Bank Governor has highlighted this good fortune, recounting the declines in the prices of many imported manufactured goods such as computers and the increases in the prices of our resource-based exports. Our command over global production is thereby increased, which is enviable, while it is sustained.

Part of the rise in the terms of trade seems likely to persist. Around the world, competition and innovation are driving improvements in productivity, and so lowering prices of manufactured goods. Global growth, greatly boosted by booming but resource-short China, has increased demand for the commodities that Australia has in abundance.

But some of the rise in the terms of trade is cyclical, due to last year’s unsustainable increase in Chinese demand for raw materials and the pumping up of US demand by the lowest interest rates since the 1930s. The Chinese authorities are now tightening their previously expansionary economic policies, and many commodity prices are 20 per cent or more below their 2004 peaks. In addition, at last the US Fed has acted to start the multi-year process of increasing US interest rates to more normal levels, to subdue the pick-up in US inflation. It is more reasonable to suppose that Australia’s terms of trade will experience a cyclical retreat than to assume there will be further increases.

And remember what followed immediately after the last steep rise in the terms of trade came to an abrupt halt, in the late-1980s. Yes, you got it without prompting: “the recession we had to have”.

In this context, it is very worrying that export volume growth has failed to deliver for many years while the share of imports in GDP has surged to an all-time high (graph 2).

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Our fearless authorities, of course, forecast that export volumes will rise and import volumes will fall in the year ahead. But this is the same forecast as made last year and the year before and the year before. Each time it has been wrong. Now a stopped clock is right twice a day, so eventually the official forecasts will prove right. But we have little confidence that they are on the money now.

The fact is that the trade deficit will remain large if export volumes are not now sharply increased and import volumes reduced through a slowdown in domestic demand growth. Unfortunately, export volumes face strict limitations from port, rail capacity and weather and almost all the domestic indicators of demand are recording confidence and strength out into the future. We can’t see the desired slowdown in imports at current exchange rates and interest rates.

What is even more alarming is that rising overseas interest rates will add significantly to Australians’ interest bill on foreign borrowings. Net overseas debt is now around 50 per cent of GDP, well above the forecast levels that so worried Paul Keating in 1986.  As global interest rates rise, our international debt service obligations will increase. A 200 basis point rate increase will – in a reasonably short time – raise our debt service payments by 1 per cent of GDP.  If this were to combine with stationary or falling terms of trade and static export volumes, Australia’s current account would be in crisis. A deficit of 7 per cent of GDP would appear only too plausible.

We say to the RBA Board: “A current-account black hole is a real possibility, far beyond the recent deficits of 5-6 per cent of GDP, which could well lead to a sharply weaker currency and a consequent sharp rise in forecast inflation. You will then have to increase interest rates in circumstances that you did not plan, at a time when markets will be fearing a credit crunch. This may not occur if you do something about it now. But if you let the situation drift, who knows? You will have only yourselves to blame.”