How Australia’s Terms of Trade is Riding the Dragon

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One of the best indications of how good Australia has had it in the last 10 years is its terms of trade. Roughly speaking, the terms of trade tell you how much Australia gets for what it sells abroad and how much it pays for what it imports. The higher the figure, the bigger the difference.

We start off with this topic for the week because the terms of trade fell in the fourth quarter for the first time since 2010. Export prices fell 1.5%, according to the Australian Bureau of Statistics. This was mostly due to a 4.5% fall in coal and iron ore prices. Meanwhile, import prices rose 2.5%, thanks to higher oil and energy prices.

To put this in perspective you have to understand how good times have been. Export prices – mostly because of record iron ore and coal prices – have delivered a huge wave of income to Australian commodity companies. Import prices, especially manufactured goods, have fallen because of the global boom in capacity and production.

You can see below that today’s terms of trade boom exceeds anything Australia has seen in previous booms. The wool booms in the 1920s and the 1950s – both war related – helped Australia ride the sheep’s back to prosperity. This time, Australia is riding the Dragon’s back to prosperity. And the dragon is made of iron and steel and zinc and copper and breathes fire made from coal.

Riding the Dragon’s Back to Booming Prosperity

Australia's term of trade

Now we don’t mean to make a mountain out of a molehill. A one-month slow down in a long-term trend is an anomaly, not a trend. But you can see how central China has become to Australia’s prosperity. Both aspects of the terms of trade – the export of iron ore and coal to China and the import of cheap manufactured goods from China – have been positively influenced to produce a record level.

This is what the Reserve Bank of Australia (RBA) calls a “positive” terms of trade shock. It’s one of three types of “shocks” academic research has identified. According to the RBA’s report (emphasis added is ours):

Three stylised terms of trade shocks are identified: a world demand shock, a commodity-market specific shock, and a globalisation shock. A positive world demand shock is associated with a pick-up in global economic activity and an increase in export and import prices. A positive commodity-market specific shock increases export prices without a corresponding pick-up in global economic activity.

Finally, a globalisation shock captures the increasing integration of emerging economies, notably China and India, into the world economy. Increased globalisation has been associated with a fall in the relative price of manufactured goods. As Australian imports are concentrated in manufactured goods this is also likely to increase the terms of trade.

At the same time, as more countries integrate in to the world economy, the demand for raw materials increases, exerting upward pressure on (commodity) export prices. Such a shock is also associated with an expansion in world output.

World output definitely expanded in the last 10 years. That tends to happen when China’s economy grows by around 8% a year for 10 years in a row. This was a kind of “demand” shock, which caught global commodity producers off guard. They’d spent 20 years not investing in much new productive capacity. And suddenly demand exploded.

This is also the “globalisation shock” the RBA paper mentions. The globalisation of manufacturing has reduced the price of manufactured goods while boosting the demand for raw materials. If you can name a country that’s benefitted from this more than Australia, we’ll bake you a cake.

But the question we’re wrestling with is how to separate the “globalisation shock” from the decline of the US dollar and the global credit boom. China’s rise – and therefore Australia’s good fortune – are directly related to Americans living above their means on credit. Americans – including the US government – have been able to do this because of the global dollar standard; a currency system that permits America to run up debts in a currency it can also print.

The whole world got in on the credit bubble. The result, you’d imagine, is an artificial level of consumer demand. And you’d further expect that demand to fall as the world deleverages. Overcapacity + falling demand = slower corporate profit growth and lower stock prices.

What’s more, the flip side of the boom in Chinese manufacturing capacity is the structural loss of manufacturing jobs in America and the Western world. Millions of middle-class workers have lost high-wage jobs that may be very hard to get back. You’d expect that to be bearish for consumer demand as well.

You’d expect a lot of things. But you never can tell what the world will bring you. This is why we’ve set aside two whole days in March to discuss the subject . The “After America” conference is currently on sale right now to those who previously expressed interest in advanced notification. If we don’t sell out by Friday, we’ll let you know more about the show in Sydney and how to sign up.

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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6 Comments on "How Australia’s Terms of Trade is Riding the Dragon"

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watcher7
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I have post on this before, but in light of the “After America” conference, a refresher on the “Anglo-American Hegemonic Cycle” may be timely; the AAHC may be viewed at http://www.members.optusnet.com.au/futurewatch/id10.htm While Europe is in for a severe crisis, it will emerge from the coming Great Depression in a lot better shape than America, with Europa replacing America as the hegemonic power – America is likely to balkanise in the aftermath of the bursting of the Government Bailout Bubble. The Future is in the East, that is, east of America. “the hills are high and the emperor is far away”… Read more »
Ross
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hi watcher! Welcome to 2012, all the usual suspects might grace us again. With Dan citing an “After America” conference I am prompted to mention Stepehen E. Ambrose’s work “To America”. Before I set forth on Ambrose I should mention how I arrived back at his door. The tempestuous route I took started with Humphrey McQueen’s defence of his friend Manning Clark in Humpy’s book “Suspect History (Manning Clark and the future of Australia’s past)”. Somewhere in there Humpy mentioned Ambrose; though for the life of me I can’t find the reference and he failed to index it. Given Ambrose’s… Read more »
watcher7
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Ross, I was not attacking China – I was outlining what I perceive as the reality in China and how it will play out. I don’t know how you could read that into my comment. You write: “Meanwhile, leave the Chinese to themselves and their culture and their politcal system”. I just don’t understand how I could be interfering with the Chinese by making an assessment of one of the biggest Bubble economies in history and its potential aftermath. Your last sentence supports my view. If I was an investor in China I would like to have some views that… Read more »
Ross
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watcher “Your last sentence supports my view” on populism maybe but I think a bit of populism is a good thing. Being now a more devout Pan Deist than ever I was before I agree with your comments on turning to God. Not sure where the 10% of white Australians comes from? And that’s from one who wrote a book about the corporatist styled redundancy of Sydney and an agrarian led spiritual rebirth.

Lachlan
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If the people turn to God they will in fact also turn to each other in love and in truth. They will come to know and resist an enemy which is not a bank or a government or a tyrant dictator. It is an unseen, ubiquitous force currently operating from within the shadows. At the same time no leadership would be seen except that which invisibly guides the individual from within.

Bev Wilson
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Why is it that the so called “experts” see only the woods and not the trees? The answer to the revival of capitalism is simply to support small business. The downfall of capitalism is centralisation. Clearly, the opposite of capitalism is control which manifests rapidly when power is given (or taken) by large corporates or governments. Look at the trees. Individuals,including small businesses are the decentralising key to prosperity and fairness. Fair pay for fair work only happens in small business because the calculations are more transparent, more accountable and therefore more reliable. As corporates (or governments) gain more power,… Read more »
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