Terms of Trade Driving Runaway Australian Inflation

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Congratulations Australia! You’re getting a $30 billion raise.

Reserve Bank economists now reckon that the recent coking and thermal coal deals inked between Aussie sellers and overseas buyers will haul in another $30 billion to the economy this year. That is not the kind of news the RBA wants to hear while it’s busy putting out inflationary bush fires in the economy. But facts are facts.

Thirty billions dollars in coal and iron ore earnings, where will it go? To producers? To investors? To mining service companies like Walter Diversified Services (ASX:WDS)?

While you think on that, let’s talk about “terms of trade” for a moment. “Terms of trade” is one of those terms of the trade that gets throw around by economists all the time. But what does it mean?

The simple definition is this: it’s the ratio between export prices to import prices. If you get more for what you sell and pay less for what you buy, your terms of trade improve. And guess what people? Thanks to this particular moment in history, Australia gets a lot more for what it sells and pays a lot less for what it buys (except for crude oil).

The chart below is taken from a 2005 Reserve Bank research paper called “Long-Term Patterns in Australia’s Terms of Trade,” by Christian Gillitzer and Jonathan Kearns.

But we’ll save you the trouble and tell you what it means in laymen’s terms. The chart shows that the terms of trade exploded in the 1950s as Aussie exports of wheat and wool increased export earnings. Today’s terms of trade ratio, by the way, is around 130, where those two dots on the right margin are. Will the index go to 1950s levels? And if it does, what will it mean for domestic spending in Australia?

In a speech given in February of last year, RBA assistant governor Malcolm Edey showed how an improvement in the terms of trade can lead to a rise in national income and, gulp, domestic demand. Think inflation.

“One of the consequences of the strong global economy, and particularly the growth of Chinese industrial demand,” he said, “has been sustained upward pressure on a range of commodity prices. Over the past three years this has lifted Australia’s terms of trade by around 30 per cent, the largest cumulative increase that we have experienced since the early 1970s.”

“It is not hard to appreciate that this provides a significant boost to incomes and spending. With exports representing about a fifth of GDP, each 10 per cent increase in the terms of trade adds about 2 per cent to the value of national income,” he concluded.

Whose income, though? This is the key question. Will the rise in export earnings lead to more spending (and if so, by who?). The answer will help determine if and how big future interest rate rises are.

According to today’s Age, “While senior Reserve Bank and Treasury officials forecast last month that Australia was heading for a boost of 10% to 15% in the terms of trade in 2008-09, the Posco deal suggests the rise could be more like 20% to 25%. Next year could see the terms of trade – the ratio of export prices to import prices – overtake the record levels of the Korean War boom in 1951.”

That’s interesting. Yesterday we mentioned that the current rise in Chinese steel production (and growth in Aussie exports of iron ore and steel) happened during the great post-war expansion in Korea and Japan, when both countries effectively industrialised and built up their manufacturing bases.

Base metals demand grew in both countries, driving them south to Australia, where Lang Hancock was flying over the Pilbara in 1952, noting that all that red earth might just possibly be iron ore. The rest, as they say, is history. But as they also say, the past is prologue. China is coming south these days too, looking to build out its industrial and manufacturing base with Aussie coal, base metals, and minerals (heck, let’s throw uranium and LNG in there too.)

Here are two scary charts for the RBA that suggest the terms of trade may improve even more in coming years, leading to more inflationary pressure in the economy via business spending.

First, when the terms of trade spiked in the 1950s, commodity prices were in a secular downtrend. What Australia was selling went up in price, while the general trend in prices for manufactured goods was down. Aussie ore went to Japan and Korea and came back, eventually as cheap manufactured goods.

Today, real commodity prices appear to have bottomed from a 200-year low around 2003. It was certainly a 20-year low. Whether the price of real commodities keeps going up, we’ll have to see. But you have a situation where the price of manufactured goods continues to go lower (more global producers) at the same time the price of raw materials is going up.

As the chart above shows, Australian export prices are rising faster than commodity prices, while Australia’s import prices are declining faster than world manufacturing prices.

Why that exactly would be the case is a bit of mystery. The paper’s authors suggest that, “Australia’s traditional mineral exports had been high value-to-bulk commodities such as copper, lead and zinc. Japan’s prominence in Australia’s commodity exports at the time is illustrated by the fact that by 1969/70 Japan imported 65 per cent of Australia’s metal ores, coal, gas and petroleum exports.”

The simpler explanation is that what Australia is exporting today-iron ore, coking coal, zinc, copper, and gold-is in greater demand than wool and what were 50 years ago, as reflected by higher prices. If anything, a recovery in the agricultural sector (rice and wheat especially) would deliver an even bigger boost to the terms of trade.

If China is the new Japan (and our theory of great post-war periods of industrialisation suggests that it is), then you see why the trend is sustainable and the terms of trade will grow even more. Export income should grow as export prices (and production volumes grow). They will only grow, of course, if business investment picks up. Business investment is the big driver of all wage and income growth, though. So if business investment grows, wages are going up.

Do you see why inflation is largely out of the Reserve Bank’s hands now? It can control domestic consumption. But it cannot control foreign consumption of Australia’s mineral exports. That’s the demand driving business investment and Aussie wage growth.

On the import side, it’s easy to see in a picture why Aussie import prices have been falling even faster than the average price of global manufactured goods: we’re getting more stuff from Asia and less from Europe. Shipping costs are much lower. But prices are lower in the aggregate because low labour costs in Asia have led to a big decline in the price of manufactured goods globally. Wage and price disinflation from Asia, you could say.

So what does it all mean? It means export earnings will grow for commodity producers unless they run into the brick wall of rising energy costs, labour market constraints, or infrastructure bottlenecks, all three of which are possible.

There are other factors too. Rising global energy prices affect producers and prices. That could crimp global demand, Asian production, and thus Aussie resources. It’s also possible that rising food and fuel prices trump falling prices for manufactured goods and lead to greater Aussie inflation. After all, food and fuel make up a greater portion of the household budget than DVDs and toasters.

Plus, 60% of Aussie GDP is consumer spending. If export earnings benefit mostly industrials and manufacturers, and they represent just 26% of all economic activity, then the effects of a huge boost in the terms of trade might be muted. Consumers will be hit hard by rising food and fuel prices while businesses, flush with export earnings, will hoard cash for the duration of the credit crunch.

And of course there’s the possibility we could have big trouble in big China. We have speculated that China’s long-term ambitions in Australia are…ambitious. But China itself a seething bundle of internal contradictions.

It is 1.2 billion people growing with great energy. But demographically, Chin is also getting old quickly and facing the health challenges that come from running an economy at breakneck speed without regard for workplace safety or the environment. It is a closed system trying to unleash the energy of economic growth but remain static politically.

Trying to move while standing still is neat trick. The only way we’ve ever seen it done is in a rocking chair, where you find motion and stasis at the same time. China’s very attempt to industrialise right now may put the raw materials it needs to do so out of its strategic reach. This means price pressures on global energy and minerals.

It leads us to a world of energy haves and energy have-nots and of agricultural haves and have-nots. Where it takes us is anyone’s guess. For Australia, for right now, it looks like it’s taken us higher.

Dan Denning
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. Dont quote me on this but i believe china will have over 40 million single males over the age of 40 in about 5 years. Traditionally their children would support them as they went into retirement/or in their case bent over and broken. What will China do with these people?

    Diggin it!
    April 18, 2008
    Reply
  2. 40 isn’t really that old…

    Reply
  3. Thanks for this story. The effect of China exporting deflation to Australia would be more clearly illustrated if you had the dramatic figures beyond 03/04 and if Hong Kong was consolidated with China.

    If the import capital equipment values were removed from the figures (EU / US origin equipment of low volume, high value) it would give a better view of the base from which to make a better short term forcast for net import price change effects.

    The effect of the Olympics on Chinese resource consumption will be proved larger than is credited (like our 2001/2 hangover). Chinese GDP growth has been extraordinary but their GDP itself is still not driving a domestic economy big enough to resist a significant downturn in export related production.

    Recent import price inflation is starting to show the effect of USD weakness (raw materials) & local wage inflation in China adds to this. The incredible production productivity increases that deflated their export prices in the past 10 years appear to be topping out short term (despite their awfull domestic transport & logistics productivity).

    My guess is that softer mineral demand will start to feed through and affect our export volumes and prices. Events in Asia tend to move more quickly than the fascinations of Chinese state enterprise planners that seek to out-Japanese the Japanese.

    Reply
  4. Apologies if the question is dumb.

    What I want to ask is, how does an improving “Terms of Trade” make inflation in general prices worse? That is, the degree to which it boosts spending/”aggregate demand” in an economy, doesn’t it also boost the “aggregate supply”, so that price levels aren’t affected like they would be if there was a boost in spending inspired only by credit?

    Thanks in advance…

    Reply
  5. The soft landing that Wayne Swan (and most bank based commentators) expect is not going to happen. Economic text books and models speak of averages. Average unemployment, average inflation, average interest rates, average rainfall, the CPI etc. The real world is more complex than this.

    Imagine Pilot Officer Swann manoeuvring a 40 year old F111-C onto a short final with his eyes shifting between the airspeed indicator, the rate of decent indicator and the runway keys – His landing gear is down and locked but he has forgotten to notice a small tire pressure indicator beeping and flashing red. Apparently the tires on the left hand side (akin to mining, resources etc.) are over inflated to bursting point. The Tyres on the right hand side (manufacturing, finance, tourism and drought impacted agriculture) have deflated. Not to worry the average pressure of the tyres is SPOT ON!

    Makes for an interesting landing but not a soft one.

    Coffee Addict
    April 21, 2008
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  6. C.A Well said, but as usual they are trying to prevent panic by telling us what we want to hear, when the crap hits the fan then they will tell us how it was out of their hands and unforseeable. Its the same old crap just a different day!

    Diggin it!
    April 21, 2008
    Reply
  7. What is the effect of the increasing price of world credit on China. How do they finance their expansion? What is the impact of the falling US dollar on China – how much of their foreign earnings do they hold in US dollars? What is the possibility that they will switch to gold?

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  8. What is the convention that stops any country from switching to gold for its foreign holdings? Why is any country holding their foreign exchange in US dollars if they are just falling in value? The US dollar does not look very stable – what is its value as a store of foreign exchange? I am muddled on all this.

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  9. Hey, I am currently completing the HSC. Reading this atricle has helped HEAPS!!! if you could send more my way it would be great!!

    Also, is China aging such a negative, as it the smaller the workforce, the better for international competitiveness. I know that Australia does not even compete on an international scale, but more competition (larger from India and Russia) would allow for prices to become even cheaper.
    Also the TOT is increasing which is inflationary, get that through Wayne Swann’s narrow minded head! Get him to define it first! haha

    Article is Great overall

    George Khoury
    June 19, 2008
    Reply

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