11/10/2013 - 04:29

Factoring in a smooth transition

11/10/2013 - 04:29

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Factoring in a smooth transition

Recent discussion of the transition from mining investment to mining harvest in Australia led me to revisit some work I did two years ago on the nature of the economic shock to the Australian economy as a result of China's rise.

At that time I argued the impact of the mining investment boom on the non-mining economy was a supply shock; that it is the falling supply of labour in the non-mining economy, as it shifts to the mining sector, which has most driven macro-economic outcomes in Australia.

For most Australians, working in the non-mining economy, the impact of structural adjustment has not been pleasant.

Circa 2003 the non-mining economy was in broad equilibrium. Then the mining boom took off and sucked around 400,000 workers into its orbit.

However at the same time, from a demand perspective, these workers are still non-mining economy households demanding goods and services like everyone else. As a result, demand expands. Effectively, the non-mining economy's capacity has shrunk despite higher demand. As a result, prices have risen and so living standards in the non-mining economy have, at best, improved only slightly.

This has been the experience of the investment phase of the boom, evident both in growth and inflation.

Inflation, too, fits in with this story. And while inflation should be high under these conditions, it has been very moderate – due to the strong Australian dollar and relatively weak global economy contributing to lower import prices.

If mining investment is about to fall from its current peaks, which seems a sound base case, what is Australia's likely economic future? What will the harvesting phase look and feel like?

As mining's investment phase winds down and fewer workers are required in that sector, supply in the non-mining economy will rise, increasing activity in that part of the economy.

Assuming an increase in demand (based on analysis that suggests exports of commodities will rise and imports of mining capital goods fall), this should more than offset the fall in mining investment.

The outcome is faster growth in the non-mining economy without the price pressures of the past five years.

But clearly there will be compositional changes that impact groups in the economy in different ways, as was the case in the investment phase. Crudely, Western Australia does worse, NSW does better.

The supply shift will be led by the return of up to 400,000 mining construction workers to the non-mining economy. The demand shift will be a consequence of higher government revenues and dividends to households (based on equity market expectations that mining companies return higher earnings rather than spend them).

The demand shift will facilitate the absorption of mining labour back into the non-mining economy. This is already being seen in NSW (though not entirely mining revenue related) as the state government pursues aggressive infrastructure investment plans.

The RBA, too, through the promotion of a housing cycle expects that this will absorb an increased labour supply.

From an inflation perspective, it's clear that wages won't be as high in the non-mining economy as they were in the mining sector.

But I tend to think it's not just wages that will help ease price pressures. In industries like transport, businesses could never afford to offer mining wages, so they tended to leave jobs unfilled. Now, as mining jobs fall, these jobs will be occupied. This is the capacity increase returning mining workers will create.

This assertion that the mining transition can be a lot more benign than current expectations suggest is dependent on at least two outcomes not eventuating – a decline in demand for commodities or, alternatively, a substantial increase in demand that leads to investment continuing.

It also suggests the RBA has an easier job. Weaker price pressures would mean a relatively moderate rate rise cycle. The caveat to this will be asset prices, particularly house prices. A combination of strong economic growth and low rates will put further pressure on house prices. This will be monetary policy's biggest challenge.

James White is senior analyst, investment markets research at Colonial First State Global Asset Management.

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