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.
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.
for The Daily Reckoning Australia