An African Divergence

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It is not every day that you can stick your finger in the eye of your largest trading partner, undermine your country’s reputation as a stable place to do business, and demonstrate your fundamental ignorance of why entrepreneurs take risks…but in his high-handed small-minded way, Kevin Rudd managed to do all of that yesterday.

Bravo Mr. Rudd!

That’s an impressive day’s work for someone in the public service. But more seriously, the underlying justification for new resource rent tax, when you get right down to it, is that wealth belongs to the government, which is free to take its “fair share” from private enterprise and then spread around wisely in Solomonic fashion. We’ll get to that philosophical issue shortly.

But the financial issue is already quite clear: mining shares got battered. Locally-listed resource shares shed about $14 billion in market value yesterday. That’s about how much the Henry review reckons would be raised by imposing a 40% “super profits tax” on Aussie miners (over and above the current corporate tax rate of 28%).

Why bother raising super annuation contributions if you’re going to reduce corporate profitability and the total return to shareholders generated by Aussie firms? It doesn’t make much sense.

Of all the issues to talk about with respect to the “super profits tax” there are three that interest us most: the reaction in China, the divergence between Aussie and African projects, and the astounding ignorance of why entrepreneurs take risks. Let’s deal briefly with each.

There isn’t any reaction in China yet to the policy change. But you can bet there will be if Aussie firms try to pass on the higher tax by raising prices on their $42.4 billion in exports to China. Of course, because of the nature of the pricing of global commodities, Aussie firms may have less pricing power relative to China than what they think (or have just achieved with quarterly benchmarks for iron ore).

That means the knock-on effect is a re-rating of Aussie companies based on where their projects are. If it is less profitable to explore and extract resources in Australia because of the 57% aggregate tax on projects, then companies will look to places with friendlier, less confiscatory tax regimes. There are plenty of them in Africa.

Out in WA, The West reports that, “Expectations that the Federal Government’s planned resources super tax could send investment dollars offshore saw investors pile into WA’s African juniors yesterday. Defying the share market slump that wiped $8 billion from the value of Australian stocks, shares in Gryphon Minerals, DMC Mining and Ampella Mining rose between 2 and 6 per cent as analysts warned local projects may struggle to secure funding.”

Diggers and Drillers editor Alex Cowie was way ahead of this trend, albeit for different reasons. About a third of his recent recommendations have major projects or operations in Africa. Alex originally cited the lower operating cost as the big driver. But with this weekend’s events, there may be another tailwind now.

To be fair, there is a provision in the Rudd government’s proposals which encourages exploration. But you wonder how many firms will take it up if the end result is the government grabbing its “fair share” of the “excess profit.” That sounds a little bit like a pimp telling his girls they’ll get new jewellery if they go out and drum up more business.

If the new tax decreases investment – as the miners claim it will – then it will lead to less exploration of Australian for new mineral and energy projects. That results in lower capital formation and fewer jobs in the domestic mining industry (although plenty of Aussies could head overseas for work). It would be ironic – and typical of a misunderstanding of how markets work – if a policy designed to capture more of the country’s mineral wealth led to a net decline in that wealth.

But before we get any further into whether the government has sabotaged the prosperity of one of Australia’s key industries, it may be a moot point anyway. Implicit in the “super profits tax” is that profits will remain “super!” But commodity markets are inherently cyclical. And the proposed policy may be based on assumption that’s about to proven invalid.

Of course that’s the argument we made in our “Exit the Dragon” report this weekend. The argument, in brief, is that the pricking of China’s real estate bubble by increased reserve requirements at commercial banks will put an end to the building boom that’s driven Aussie resource prices.

Our old friend Dr. Marc Faber thinks it – a crash in the Chinese stock market – could happen quite soon. Dr. Faber told Bloomberg TV, “The signals are all there, the symptoms of a major bubble are all there. The Chinese economy is going to slow down regardless. It is more likely that we will even have a crash sometime in the next nine to 12 months.”

He also cited the property bust and subsequent depression that followed the 1873 World Exhibition in Vienna, which you have to admit is doing your homework on the relationship between large fixed asset investment and later busts. You can also find a more contemporary example in the way Chinese stocks peaked and then declined before the 2008 Beijing Summer Olympics began. Take a look at the charts below.

SSE Composite Index
S&P 500 Index, RTH

What do the charts show? Shanghai’s stock market peaked in late 2007, about the same time the S&P peaked. But its decline was more immediate and gradual, if less panicky than the S&P’s performance. Shanghai also bottomed well ahead of the S&P 500. So what?

The Chinese stimulus kicked in sooner and had a more visible effect on stock and real estate prices than nearly anywhere else in the world (except maybe Australia). The debut of the Expo is merely anecdotal and kind of mile marker. But like the decline in stocks before the Olympics, the markets could be telling us that China’s construction boom is over. With banks liquidity tightening and industrial and material stocks struggling, all the signs are there of a market rolling over.

Incidentally, the Expo sounds and looks amazing. China expects nearly 70 million visitors while it lasts, which would put the Olympics to shame. You can see how it’s just the sort of project that would boost construction spending. And then?

What is it with Americans and their constant predictions of an Aussie house bubble? GMO analyst Edward Chancellor – whom we quoted in our China research – says Aussie house prices are 50% of fair value. He told Katherine Jiminez at the Australian that, “My view is Australia had a private sector credit boom just like the US and the UK and it had a real estate boom.”

So far, so good.

“Those are facts and you can’t paper over them. In this environment house prices rose last year [by 20% in fact]and that seems to me to actually have exacerbated the problem. The problem is the bubble and that hasn’t gone away.” He added that rising interest rates “tend to generate the collapse.”

Many property advocates say the comparison between Australia and the U.S. is not apt. Australia didn’t have a subprime lending boom (the FHOG doesn’t count!), the population is growing and immigration is high (underlying demand), there is a lack of supply, credit is still plentiful, and Australians have a preference to live in their own homes.

The alternative view is that Australian households are badly over-leveraged in residential housing. Debt has risen faster than incomes and when interest rates rise – they do that sometimes – the pain will follow. You could argue that the government won’t allow rates to rise. But good luck with that.

Incidentally, we have agreed in principle to debate one of Australia’s foremost property experts in July in Sydney. We can’t say anything more about it now. But details will follow.

Finally, has the government fatally misunderstood the cyclicality of commodity markets and the whole notion of risk taking?

One of the intriguing aspects of the debate about the resource rent tax is what the theoretical “adequate return” on a project is. The government used long-term government bond yields as the benchmark, and those are around 5.75% right now. The tax kicks in after that rate of return is reached.

You could forgive a career diplomat for not understanding the nature of risk-taking. Entrepreneurs don’t go into business and take tremendous risks with their time and talent to earn back what you could get in a government bond. Otherwise, why try to capture huge profits by taking risks?

Profits are incentive to produce goods and services. Take away the incentive and you take away the human energy that goes into producing such a large variety of goods and services. The market regulates the returns on projects through supply and demand and transparent pricing. Resource companies make long-term decisions about what to invest based on their forecasts of commodity prices.

The government has essentially butted in and distorted the economics of capital spending plans by blindly assuming resources prices are going to stay high and that it’s going to capture its “fair share.” That’s pretty short-sighted. But more importantly, it shows how badly policy makers misunderstand why entrepreneurs take action – to create surplus value and capture profit.

If the government says “every time you create surplus value we’re going to take it,” who’s going to bother? This is the government behaving as if it is already a majority shareholder in private companies and free to do what it likes with retained earnings, like dole them out to its favorite projects. It’s pretty cheeky – perhaps even immoral – for an institution that didn’t have that much to do with creating the surplus value in the first place.

Now, whether Australia is doing the most to make itself richer from the resource boom is certainly a fair question. But the Rudd government seems to have jumped the shark by deciding that the risks taken by the private sector are its own, but the benefits and profits belong to the public. You wouldn’t blame foreign capital for finding that a disturbing and high-handed attitude.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. I think that we are misunderstanding Uncle Kevin. His goal is obviously to be remembered as the “most” financially incompetent leader that this nation has and (hopefully) will ever seen.

    If he has demonstrated one that only, that is that centralized managment of this huge country is simply beyond the capacity of a small city situated in a remote south-eastern part of the country.

    Reply
  2. So it would seem that the government is treating mining companies the opposite of the banks…

    Banks get to privatise profits and socialise losses (i.e. bailouts anyone?) whereas Mining companies get to socialise profits and privatise losses.

    What a strage world we are coming to inhabit!

    smeggett

    smeggett
    May 4, 2010
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  3. Clearly the govt are not very well read in economic history which in Australia is littered with booms and busts like the gold rush of the late 19th Century. The interesting point is that with Australians presently “feeling” wealthy by virtue of low unemployment, plenty of govt services and handouts, housing equity (on paper), and a high AUD it seems that the ALP is trying to appeal to the majority by ratcheting up the sense of entitlement and euphoria. I think this policy indicates a turning point, a brazen attack on the miners to further entrench the need for big ALP style government, will the ALP survive and get this implemented or is this the signal to the majority that we need a new government.

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  4. I fully support Kevin Rudd’s stand on the resource tax. It’s about time.
    Why – can someone tell me, should we Australians sit by and allow mining giants such as Rio Tinto to rip billions out of the country for the benefit of their shareholders who are mostly foreigners? I am not a communist but the resources of this country should belong to the people collectively (we are a “commonwealth” after all) and therefore we should have the right to determine who uses it and what rent we charge foreigners for use of it.
    I am not sympathetic in the least to the whining of the apologists for large mining interests who see this as killing the resources boom and restricting the endless exploitation of what are very finite resources.
    If Kevin Rudd is incompetent – in my opinion it is because he has allowed this resource boom to continue too long to the extent where it has been largely responsible for a gross over valuation of the Aussie Dollar and a property bubble that when it does burst will cause considerable misery. An overvalued dollar (25% in excess of its USD Purchasing Parity) has resulted in the hollowing of the economy to the extent that only 9% of our economy is now manufacturing based.
    For these reasons, surely more should be done to tame the resources boom and the dollar, disengage from over reliance on mining and China and allow our economy to build a more solid export based manufacturing base.
    Otherwise our future job profile will be limited to ever more public servants, real estate agents and banksters.

    David Bode
    May 4, 2010
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  5. I don’t like this trend, David Bowie. You pinkoes are stealing my minus points. Minus four _already_!!!~ As DRA’s current record-holder, I resent your socialistic anti-materialism. Ignore this confused soul, DReAders. Let’s keep the record in WA, along with us ferals…!!~

    Biker Pete
    May 4, 2010
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  6. Just saw Steve K on the TV tonight. His recommendation was to sell your house. I think he is serious this time. So, if you live in Melbourne, congratulations, you just made 20% on that trade (and tax free at that).

    Gee David, you must be a big communisto, big communisto. -4! The Liberal Party must be voting tonight.

    smallcap
    May 4, 2010
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  7. Macca, If we slug the (Chinese owned)mining companies, they won’t be able pay miners over the odds, who in turn won’t be able to pay Biker’s over the odds rent. He will have to sell his massive portfolio. That will cause the housing market to tumble. Me and Steve will each then be able to afford a house (do i want to live in WA?????) and all will be well with the world.

    Don’t see your problem

    smallcap
    May 4, 2010
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  8. err DR needs to edit better… or perhaps they are property bulls after all?

    “….Aussie house prices are 50% of fair value”

    After reading the article you would get the impression from DR that mining entrepreneurs just start digging and don’t bother with any financial calculations (NPV, DCF, rNPV)…..but amazingly.. even though I am not a mining insider, I have a canny feeling that no project goes forward without knowing the exact return and risks before it starts.

    Therefore, using the risk free rate as a benchmark for a successful project is a fair call by the government oiks….. they had to use something so at least they haven’t just plucked a number out of the air.

    Reply
  9. “Just saw Steve K on the TV tonight. … I think he is serious this time.”

    Now THAT one would have got you the Monthly Award, Steve!~ :)

    Biker Pete
    May 4, 2010
    Reply
  10. Hi Dan

    I wish and pray that you will find you are living on top of an oil well so that I may come into your backyard, sink a couple of oil rigs, extract and sell billions upon billions of crude oil and only give you pennies for every dollar of pure profit I make. And to show my appreciation, I will even leave you a big hole and all my attendant mess for you to clean up. Seems it is OK for you to collect rent if you are a private individual or corporation but not if you are the people of Australia.

    Reply
  11. Personally I think the mining industry could do with a bit of a cutback. Besides the environmental damage that has been quite unchecked, and the farming land that is being dug up for coal.. the mining resources that remain on this planet are quite finite (and I mean within our lifetimes finite at the rate we are digging it up). It follows that if Australia is a country with significant resources then they will be more valuable in future. It has long been the worry that Australia is heavily dependant on Mining with a “2 speed” economy. If mining were to cease abruptly because unchecked, out of control exploration and expansion continued..this country would be in a pickle.

    I do agree Kev is playing a risky game though, and it could backfire with the mining companies. Maybe then Australia will have to start depending on our other talents like the scientists from CSIRO that have fled the country looking for opportunity. My money is on recycling companies, when the holes in the ground run out garbage dumps will be gold mines.

    Beyondtool
    May 4, 2010
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  12. the value of natural resources will increase exponentially – for ever – so why rush to sell them now? should we not focus on value adding anyway? and renewables. digging up dirt is a copout.

    Reply
  13. If the XYZ company rather than the governments had the power to charge the miners royalties the DR and its stable mates would have been recommending XYZ as a buy. And why wouldn’t they have – the XYZ compaqny would have been able to easily justify increasing royalties because of the increased revenue the miners have been receiving for their product. If I was a share holder in XYZ I would expect the directors to maximise return for me. As a citizen / taxpayer in good old Aussie I expect our elected representatives to get the best return for me as well. I do not dump on the govt for making the same considerations as would have been made by the market place. The question is what will the final legislation look like. When that is on the table it will be time to judge. Reportedly there are some sweeteners for start ups which is a plus. I have worked a long time with EPCM companies and owners on mining and metalurgy projects and know well the hardest hurdles are usually at the start not in the mature producing stage. Also from what I can tell the scheme / proposed rent tax could reduse costs if the tail falls out of commodities. The DR has been telling us that could happen – Exit the Dragon.

    Maybe I am getting old. I do not seem to be able to get the angst on these issues any more. Remember Jimmy Marbo and land rights. There was plenty of angst about that. It was surposed to finish off the mining industry for good. Since then we had the biggest mining boom we ever had.

    I have a few shares in some of the miners. Nothing in the Henry review has made me feel inclined to sell them yet.

    Charfcutter
    May 5, 2010
    Reply
  14. Daniel,

    BUT <– and look it is a big but.

    IMHO the life of some (maybe even most) resources is also finite.

    Dig it up and sell it as quick as we can I say!

    We will either naturally progress to sustainable replacements and the resources in the ground will stay there or we will run out and necessity being the mother of all invention we will rapidly develop replacements.

    Reply
  15. From [B]usiness [S]pectator this morning;

    Aust building approvals surge in Mar
    Total dwelling unit approval figures smash expectations as rate rises fail to cool demand. 11:46 AM

    The JoyeBoy must be about to blow his load!

    Good news for BIKER a.k.a. ‘Platinum’ Pete too. How is your platinum going?

    Reply
  16. I agree with you prozak that the only way out of this mess is through innovation. That can only move forward if it is encouraged and fostered in allowing people to meet their potential and also allow them to enjoy the fruits of their labours. How would this be best achieved is the big question.

    On the weekend I picked up that 80’s movie “Revenge of the Nerds” from a bargain bin for $3. I enjoyed it still (a good amount of good old 80’s t&a helped :) )and it got me to thinking that it represents a theme that is the last part of the twentieth century ie it was when the Nerds finally came good and got their revenge which continues to this day. The geeky guys who stereotypically used to read too much science fiction, play with their ham radios and have an overidding interest in electronics changed the world and the ubernerds made their fortunes (Bill Gates anyone?).

    It is of course simplistic, but I think it illustrates the same theme of how innovation has improved and changed things and which ultimately means that we get more from less. Yes, it has also come with downsides but I think the positive outweighs the negatives in this case.

    Reply
  17. “…and the ubernerds made their fortunes…”

    And still are. I could bore you with a few stories, but few here would believe them. Suffice it to say that I’d never have _personally_ believed such things possible in my lifetime… or my children’s… .

    The way forward is technology. When you think about it, it has always been the way forward… with a few quick backward sprints along the way…

    Biker Pete
    May 5, 2010
    Reply
  18. Never went into either platinum or lithium, Justin. Missus has me on too short a leash. ;)

    Property is doing well in WA. We’re not sure about that 16% rise they’re touting. Our land is appreciating at around 13%… and my guess is housing may be close to that. Rents are going ballistic…. crazy… up around $50 pw. We’ve left ours at existing levels. All great tenants.

    Our new rental, being completed any day now, will pick up $20 pw more than we’d planned, though. There will be a queue, even though it’s our smallest yet. One we just signed up for on Monday is 70m2 larger. It should be completed in time for Colin Barnett’s extra $4K for FHBs, early next year.
    In line with many suggestions in this forum, the extra $4K will be solely for new homes, rather than existing stock.

    In retrospect, looking back at the last three years, we definitely paid too much for one great block… and picked up two good ones quite cheaply. Overspent on one very impressive house… and came in on budget with all the rest. Still learning from our mistakes… . :)

    Biker Pete
    May 5, 2010
    Reply
  19. “One we just signed up for on Monday is 70m2 larger. It should be completed in time for Colin Barnett’s extra $4K for FHBs, early next year.”

    Unless your rorting the system, that’s extra 4k is of no use to you.

    As for Uber nerds.. Back in 94/95 a friend of mine suggested I buy some shares in a tech stock that was coming onto the market.. he knew the guy and said I should buy some shares at 20cents each.. the company is a winner. I did not buy any, I thought the technology “dot com” boom was not going to do much. The guy he knew…Steve Outtrim.. the company…Sausage Software.. I could have made a sh!t load of money if I had acted on that tip.

    Stillgotshoeson
    May 5, 2010
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  20. Shoes, I acted on iinet at 20c. I _made_ a shipload of money. (Lost some of it on a winery adjacent our property…!)

    Ubernerds? I was talking about my kids. MMs in their mid-20s. I taught them Basic back in the mid-eighties, when they were pre-schoolers. Now I watch, and learn, in awe… .

    The $4K? It simply positions us, nicely. We build for under $350K. We sell under $400K. Rorting the system? Why? We’re _entirely_ legal. We keep the most detailed, meticulous _daily_ records. There’s no need to cheat, if you know what you’re doing. But as I say, we’re still learning our craft, even after 32 very active years practising it… . :)

    Biker Pete
    May 5, 2010
    Reply
  21. “… they won’t be able pay miners over the odds, who in turn won’t be able to pay Biker’s over the odds rent. He will have to sell his massive portfolio. That will cause the housing market to tumble…”

    Wouldn’t call our portfolio _massive_, smallcap. We’re comfortable. How do we define ‘comfortable’? In our case, it simply means our debts are completely covered by a.) cash in offsets; b.) our Super, the tax on which is either 1. exempt; or 2.) already paid, so we can access monthly tax-free TTR cheques, on top of _all_ other income.

    Jeez, I hope you guys are taking notes… . I’d hate to think all this free mentoring is just PBS.

    Biker Pete
    May 5, 2010
    Reply
  22. Every Australian has already benefitted from the mining boom by way of increased asset prices across the nation. Demanding much more will simply reduce the risk/reward ratio for mining companies. Reduce it too much and they will risk rewards elsewhere (mining companies are re-assessing expansion plans here already, throwing mining towns into chaos). Then we’ll be left with dirt in the ground.
    So what if every Australian owns 50 tons of iron ore somewhere out in the WA desert? Does it employ your extended family? How do you retire on it? Maybe the value of the dirt will increase over time. Or maybe miners will spend so much elsewhere they will eventually find an unlimited cheaper source in Central Asia or Africa. Then what happens? Enjoy the mining boom while it lasts, but don’t get too greedy. Miners make massive profits because they take massive risks. To extrapolate the something-for-nothing mentality, how about we whack a super tax on banks? They are taking “our” money from the Reserve Bank and making a huge profit on it. Or what about farmers taking “our” water and “our” nutrients out of the ground? Super tax them all. Don’t get me started on fishermen taking “our” fish.
    Just the mere suggestion of Rudd’s super resource tax has spooked international investors and created uncertainty. The increased risk, whether there or not, is perceived as such. Investors will, and have already begun, to pull their investment money out of Australia. Shares will slump, interest rates will rise, unemployment will rise, home prices will stagnate, superannuation will dwindle, our taxes will increase. We’ll get our fair share of all that.
    Actually, we all “own” a few cubic metres of natural gas buried deep under Queensland. Personally, I’ll risk a little bit of my money in some company who can find it, drill it and sell it on my behalf. Otherwise, 40% of nothing is still nothing.

    Peter Kahlbaum
    May 8, 2010
    Reply
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    rocking chairs
    January 2, 2012
    Reply
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