Building a National Economy Around the Housing Industry

With each passing day it becomes more obvious that Australia is in the grip of a housing dementia. Let the madness and unafforadability multiply!

House prices were up 3.3% nationally in the second quarter of the year, according to Australian Property Monitors. The group said that the weighted average median house price in the most expensive capital city suburbs was $796,559. In the slightly less expensive suburbs the weighted average median house price was $405,872.

Ouch.

Aussie stocks are up as we write, bucking the global trend from yesterday. This comes after a 7% retreat by Chinese stocks in Shanghai and lower stocks in New York. What happened in China? Well, China's benchmark CSI 300 Index was up nearly 93% for the year before yesterday's retreat. China's monetary authorities have ignited a speculative bubble and made noises about reining it in yesterday.

Bloomberg reports that Chinese stocks, "Plunged amid speculation the central bank is poised to order lenders to set aside larger reserves, Beijing-based Caijing magazine reported today on its Web site. Market News International said Chinese equities fell on speculation regulators will increase a tax on stock trading."

Yesterday we asked the question of what would make Australia's economy grow in the next twenty years. We return to that question today. The Reserve Bank has said that Aussie banks will have to move cautiously as they repair their balances sheets. This suggests growth through debt may be harder to achieve. The RBA also said that the household sector's twenty year credit binge is over (now that asset prices are returning from orbit). Again, growth through debt is looking dubious as a national survival strategy.

Let's also assume that the government cannot borrow its way to larger stimulus payments. With lower spending forecast for government, businesses, and households, you begin to wonder if Australia's economy has a home grown engine, or if it will rely on something else, or someone else beyond the borders. If domestic demand falls, that leaves housing as the only industry firing on all cylinders (for now).

Now you can try building a national economy around the housing industry. But what you get is a nation of mortgage lenders, builders, real estate agents, speculators, and bombastic television presenters. You also get a huge speculative bubble. It's been tried in America and didn't work out so well.

If not housing, then why not resources? "Over the medium term," said Glenn Stevens earlier this week, "the emergence of China (and other countries such as India) will continue, and will offer opportunities for Australia." This is not news. But what the Governor said next is newsworthy.

"If commodity prices do stay at their relatively high levels on the back of strong emerging world demand, the mineral extraction sector and all those parts of the Australian economy that service it and feel its flow-on effects, will expand. Other sectors, will, relatively, contract over time."

Hmmn.

Does this make the Aussie economy a one trick resource pony? And even if it does, so what? Investors can still profit by finding the lowest-cost mineral extractors with the best ore bodies. As Mr. Stevens noted, even the correction in commodity prices has left them at higher inflation-adjusted levels that previous corrections. Prices came off. But they didn't crash permanently. Stevens doesn't think they will, either.

"A significant structural rise in demand for energy and resources has occurred, as a result of the cumulative growth of the emerging world. This seems more likely to be a feature of the international economy for some time than to go away," he says.

That could either be very true, or famous last words before a burst Chinese credit bubble rips the legs off of Australia's economy. But we'll go along with the Governor in the assumption that China's emergence as an industrial giant is a decade's long affair. It will have its ups and downs. But the general trend will be mostly up, accounting for the structural rise in demand for energy and resources."

It sounds, generally, like pretty good news. Of course, you want to be more than just a giant quarry. Wages and profits will be higher for Aussie firms if they can figure out ways to increase productivity and add more value. Investors can capture some of these rising profits and productivity increases through dividends or share price gains.

But adding value in the resource extraction business-and capturing that value added as an investment income-is not a simple proposition. The biggest value add (with the biggest profits) comes higher up the economic food chain (somewhere between retailing and pure intellectual property, where you produce nothing physical, but still collect rents or royalties on your production).

Australia's national income could benefit from a few industries higher up in the chain of production. But the country's current position is not a terrible one to be in either. That's not to say there aren't a few risks with hitching your wagon to China's rising star.

"If we are more integrated into China's expansion," Stevens said, "will be similarly more exposed to the consequences of whatever might go wrong in that country. So our understanding of how the Chinese economy works and what risks may be accumulating there, will need continual work."

Speaking of accumulating risks, one final note today. Reuters reports that, "The U.S. Treasury sold $39 billion in five-year debt Wednesday in an auction that drew poor demand, raising worries over the cost of financing the government's burgeoning budget deficit." The big-to-cover ratio for the five-year notes was just 1.92, its lowest level in a year.

Will a U.S. bond auction fail this year? It's not likely. The Feds will rig it to avoid that. But if investors are getting choosier about financing government debt, you wonder how that may affect the ability of the Australian Office of Financial Management to fund this country's growing fiscal deficit....

Dan Denning
for The Daily Reckoning Australia

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