The Implications of Falling Commodity Prices for the Australian Economy

Scott Brian TilburyThe University of New England

FIRST PRIZE

RBA/ESA Economics Competition 2015

The Economic Society of Australia Incorporated

Central Council

     

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The  growth  in  foreign  demand  for  key  Australian  exports  has  created  a  surge  in  

our  terms  of  trade  that  is,  both  in  magnitude  and  duration,  without  precedent  in  

our  economic  history.    This  has  been  a  primary  impetus  for  consistent  economic  

growth,  rising  real  incomes  and  strong  currency  appreciation.    However,  with  the  

onset  of  lower  commodity  prices,  Australia  can  no  longer  rely  on  the  resources  

sector  to  sustain  future  economic  growth.    The  onus  for  policy-­‐makers  is  to  

improve  the  productivity  and  competitiveness  of  our  non-­‐mining  industries,  

whilst  averting  economic  stagnation.  

The  dramatic  rise  in  the  commodity  price  index  since  2002  (Figure  1)  reflects  

growing  demand  from  emerging  economies  for  base  metals,  energy  and  

agricultural  products.    In  particular,  the  rapid  industrialisation  and  urbanisation  

of  China  has  generated  substantial  demand  for  bulk  commodities,  with  export  

prices  for  iron  ore  and  metallurgical  coal  peaking  at  more  than  600  per  cent  

above  their  2002  levels  (Robson,  2015,  p.  307).    

However,  the  commodity  prices  that  have  hitherto  underpinned  Australia’s  

favourable  terms  of  trade  have  fallen  sharply  from  their  2011  peaks  (Figure  2),  

and  will  probably  trend  lower  as  China’s  economic  growth  moderates  

concurrently  with  expanding  global  supply.    Burgeoning  commodity  prices  

precipitated  a  sustained  reallocation  of  labour  and  capital  into  mining  and  

mining-­‐related  industries  (Connolly  &  Orsmond,  2011,  p.  32).    However,  this  

structural  shift  is  set  to  reverse  as  commodity  prices  trend  lower.  

For  our  mining  sector,  the  capital  stock  is  well  developed.    The  capital-­‐intensity  

of  resource  extraction,  and  an  initial  shortfall  in  productive  capacity,  triggered  a  

large  and  sustained  inflow  of  foreign  and  domestic  capital.    Mining  investment  

has  far  exceeded  any  other  sector  of  the  economy  (Figure  3),  rising  from  2  per  

cent  to  over  8  per  cent  of  GDP  in  2013  (Garnaut,  2013,  p.  90).    However,  lower  

commodity  prices  reduce  the  incentive  for  capital  and  exploration  expenditure,  

and  the  incidence  of  new  resource  projects  has  declined  considerably  

(Department  of  Industry  &  Science,  2015,  p.  9).      

       

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Thus,  the  defining  characteristic  of  the  production  phase  will  be  a  substantial  

increase  in  output  from  existing  assets,  particularly  for  iron  ore  and  liquefied  

natural  gas  (Bishop  et  al.  2013,  p.  47).    Although  considerable  uncertainty  exists  

over  future  price  movements,  the  forecast  expansion  in  production  volumes  may  

not  be  sufficient  to  sustain  long-­‐term  revenue  growth  in  most  markets  (Figure  

4).    Export  earnings  for  the  resource  and  energy  sectors  declined  by  11  per  cent  

year-­‐on-­‐year  for  2014-­‐15  (Department  of  Industry  &  Science,  2015,  p.  7).    

Furthermore,  the  domestic  impact  of  increased  production  will  be  more  muted  

relative  to  the  investment  phase,  as  the  mining  industry  is  largely  foreign-­‐owned,  

and  the  majority  of  income  is  repatriated  overseas  (Sheehan  &  Gregory,  2013,  p.  

129).  

A  sustained  deterioration  in  commodity  prices  will  precipitate  some  industry  

rationalisation,  due  in  part  to  over-­‐capitalisation  during  the  boom.    There  is  

evidence  that  this  is  already  occurring,  both  domestically  and  abroad,  as  the  

profitability  of  low-­‐grade  and  high-­‐cost  producers  is  increasingly  impaired.    For  

example,  junior  miners  of  iron  ore  are  considered  unsustainable  at  current  

prices  (Saunders,  2015).    Additionally,  the  production  phase  is  less  labour-­‐

intensive  and  mining  sector  employment  will  fall  as  large-­‐scale  resource  

investment  subsides  (Figures  5-­‐6)  (Bishop  et  al.  2013,  p.  45).    

The  commodity  price  boom  greatly  amplified  economic  output  in  certain  

industries  proximate  to  mining  such  as  construction,  transport,  utilities  and  

business  services  (Figure  7).    By  2011,  mining-­‐related  activity  represented  

around  9  per  cent  of  GDP  (Gruen,  2011,  p.  14).    However,  these  industries  are  

typically  comprised  of  firms  that  are  disproportionately  reliant  on  mining  

contracts  and  are  correspondingly  vulnerable  to  any  mining  sector  contraction.  

A  major  corollary  of  the  mining  boom  has  been  a  sustained  appreciation  of  the  

Australian  dollar  in  trade-­‐weighted  terms  (Figure  8).    The  real  exchange  rate  has  

strengthened  in  conjunction  with  our  terms  of  trade  (Figure  9),  as  higher  export  

prices  relative  to  import  prices  stimulate  foreign  demand  for  our  currency.    The  

ensuing  rise  in  net  exports  has  been  augmented  with  large  net  capital  inflows  to  

     

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support  mining  sector  investment,  pushing  the  Australian  dollar  to  its  highest  

levels  since  Federation  (Garnaut,  2014,  p.  308).      

This  has  had  important  ramifications  for  trade-­‐exposed  sectors  of  the  economy,  

including  mining.      A  higher  real  exchange  rate  makes  our  export-­‐oriented  and  

import-­‐competing  firms  less  competitive  because  domestic  goods  and  services  

become  more  expensive  relative  to  their  foreign  counterparts  (Banks,  2011,  p.  

2).    The  mining  boom  has  also  generated  competition  for  capital  and  labour,  

which  increases  domestic  costs  of  production  (Bishop  et  al.  2013,  p.  39).    These  

factors  can  precipitate  a  structural  decline  in  trade-­‐exposed  industries  outside  

the  booming  sector  -­‐  a  phenomenon  known  as  ‘Dutch  disease’  (Corden,  2012,  p.  

290).      Australia’s  mining  boom  has  particularly  affected  output  and  employment  

in  manufacturing  and  agriculture  (Figure  7),  although  this  merely  reinforces  a  

trend  that  has  been  apparent  since  the  1970s  (Banks,  2011,  p.  4).    

Importantly,  any  tendency  towards  ‘Dutch  disease’  weakens  as  commodity  

prices  fall.    Lower  mining  investment  facilitates  the  movement  of  labour  into  

non-­‐mining  sectors  of  the  economy,  easing  wage  growth  (Plumb  et  al.  2013,  p.  

11).    A  lower  real  exchange  rate  shifts  foreign  and  domestic  demand  towards  

domestic  goods,  making  our  export-­‐oriented  industries  more  competitive  

(Blanchard  &  Sheen,  2013,  p.  435).    Price-­‐sensitive  exports  such  as  tourism,  

education,  agriculture  and  high-­‐value  manufacturing  are  all  net  beneficiaries  

with  a  weaker  Australian  Dollar.    For  example,  every  1  US  cent  depreciation  of  

our  currency  in  nominal  terms  yields  a  net  increase  to  farming  incomes  of  

approximately  $320  million  (ABARES,  2015,  p.  35).    

The  long-­‐term  prospects  for  our  trade-­‐exposed  industries  are  encouraging,  as  

continued  development  and  rising  incomes  in  Asia  will  sustain  demand  for  a  

broad  range  of  Australian  tradables  (Plumb  et  al.  2013,  p.  39).    In  particular,  the  

services  sector,  which  comprises  nearly  80  per  cent  of  Australia’s  GDP  (Banks,  

2011,  p.  5),  is  well  placed  to  benefit  from  the  anticipated  shift  in  Chinese  

consumption  towards  services  (Plumb  et  al.  2013,  p.  41).  

     

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However,  any  recovery  in  non-­‐mining  sectors  will  be  partly  hampered  by  

investment  lags  and  hysteresis  effects    (Sheehan  &  Gregory,  2013,  p.  133).    Non-­‐

mining  business  investment  has  slowed  in  recent  years  and  remains  at  historical  

lows  as  a  share  of  GDP  (Atkin  et  al.  2014,  p.  57).    The  deterioration  in  our  terms  

of  trade  and  a  weakening  exchange  rate  will  cause  real  per-­‐capita  incomes  to  fall.    

Any  subsequent  weakness  in  consumption  will  have  a  multiplying  effect  on  

aggregate  demand,  reinforcing  the  contractionary  effects  of  lower  aggregate  

investment.    If  Australia’s  economic  output  stagnates,  non-­‐tradable  sectors  such  

as  as  health  and  retail  will  be  proportionally  more  affected.    

Australia  can  no  longer  rely  on  resource  exports  for  its  future  prosperity.    Policy-­‐

makers  must  support  the  structural  adjustment  away  from  mining  activities,  

whilst  negotiating  an  impending  output  gap.    In  this  context,  Australia’s  existing  

framework  of  interest-­‐rate  setting  to  target  inflation  and  support  full-­‐

employment  continues  to  be  appropriate.    It  is  important  to  note  that  the  

principal  mechanisms  for  achieving  a  smooth  economic  adjustment  to  the  terms-­‐

of-­‐trade  shock  occur  somewhat  autonomously,  given  our  institutional  settings.      

Our  flexible  exchange  rate  regime  has  allowed  the  strong  foreign  demand  for  

domestic  goods  to  manifest  primarily  through  currency  appreciation  rather  than  

an  inflationary  episode  (Battellino,  2010,  p.  67).    As  the  mining  boom  wanes,  the  

depreciation  of  the  Australian  dollar  will  encourage  foreign  demand  for  non-­‐

mining  exports,  which  will  help  support  economic  growth  and  provide  a  more  

balanced  structure  to  the  economy.      

Australia’s  relatively  de-­‐centralised  wage-­‐setting  arrangements  have  ensured  

that  wage  growth  in  the  mining  sector  has  not  overly  affected  other  sectors  of  

the  labour  market  (Gruen,  2011,  p.  9).    This  has  curbed  inflationary  pressure  and  

will  assist  the  more  fluid  reallocation  of  labour  to  other  sectors  of  the  economy  

as  the  mining  boom  unwinds.    

The  key  challenge  now  facing  policy-­‐makers  is  the  manner  in  which  full-­‐

employment  output  can  be  achieved,  without  compromising  the  ability  of  

monetary  and  fiscal  policy  to  respond  to  future  economic  shocks.    Monetary  

     

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policy  is  the  more  useful  instrument  to  this  end.    In  the  short-­‐term,  policy  

settings  must  be  consistent  with  achieving  a  sustained  real  exchange  rate  

depreciation  to  support  trade-­‐exposed  sectors  and  provide  a  more  balanced  

profile  for  economic  growth.      

According  to  the  Mundell-­‐Fleming  model,  expansionary  monetary  policy  under  a  

flexible  exchange  rate  regime  leads  unambiguously  to  a  depreciation  of  the  

domestic  currency  and  an  improvement  in  the  trade  balance  (Appleyard  &  Field,  

2014,  p.  675).    A  lower  interest  rate  stimulates  investment  and  economic  output,  

which  initially  increases  imports,  creating  an  incipient  deficit  in  the  balance  of  

payments.    This  is  reinforced  by  an  outflow  of  short-­‐term  capital  due  to  interest  

rate  parity  effects,  causing  the  exchange  rate  to  depreciate.    The  depreciation  

leads  to  an  increase  in  net  exports,  with  the  current  account  effects  ultimately  

complementing  the  initial  monetary  stimulus  (Appleyard  &  Field,  2014,  p.  676).  

Thus,  as  commodity  prices  weaken,  the  Reserve  Bank  of  Australia  (RBA)  can  

support  income  and  employment  in  the  short  term  with  monetary  expansion,  

which  will  place  further  downward  pressure  on  the  exchange  rate.    This  will  

support  the  recovery  of  trade-­‐exposed  sectors;  with  the  trade  balance  in  a  

stronger  position  than  if  expansion  is  achieved  through  the  budget  alone  

(Garnaut,  2013,  p.  98).    Furthermore,  reducing  our  exposure  to  foreign  debt  

helps  redistribute  real  incomes  and  consumption  from  current  to  future  

generations  (Garnaut,  2013,  p.  100).  

However,  an  over-­‐reliance  on  expansionary  monetary  policy  also  presents  

systemic  risks.      Inflation  is  not  the  immediate  concern  because  inflationary  

expectations  have  remained  well  anchored  (Bishop  et  al.  2013,  p.  39)  and  

inflationary  pressure  for  both  tradables  and  non-­‐tradables  remains  subdued  

(Plumb  et  al.  2013,  p.  11).    Rather,  it  is  the  likelihood  that  a  further  reduction  of  

150  basis  points  or  more  will  effectively  end  the  RBA’s  ability  to  use  

conventional  policy,  as  Australia  would  be  approaching  the  zero  lower  bound  

(Sheehan  &  Gregory,  2013,  p.  134).    This  would  compromise  Australia’s  ability  to  

respond  to  future  economic  shocks.      

       

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Secondly,  a  prolonged  low  interest-­‐rate  environment  encourages  property  

market  speculation.    Despite  a  renewed  focus  on  prudential  regulation  since  the  

Global  Financial  Crisis,  there  is  an  emerging  asset-­‐price  bubble  in  Australia’s  

major  cities  that  may  pose  a  systemic  threat  to  our  banking  system.  

Given  the  increasing  mobility  in  international  capital  markets,  the  use  of  fiscal  

policy  to  stimulate  output  and  employment  is  theoretically  far  less  effective.    

Assuming  flexible  exchange  rates  and  relative  mobility  in  short-­‐term  capital  

markets,  the  expansionary  effect  of  an  increase  in  government  spending  is  

dampened  by  foreign  sector  adjustment  (Appleyard  &  Field,  2014,  p.  674).    Fiscal  

stimulus  increases  domestic  output  and  places  upward  pressure  on  interest  

rates  for  a  given  money  supply.    This  produces  an  incipient  surplus  in  the  

balance  of  payments  due  to  net  capital  inflows,  which  causes  the  domestic  

currency  to  appreciate  (Mankiw,  2013,  p.  363).    The  stronger  exchange  rate  

reduces  net  exports,  which  dampens  the  impact  on  economic  output  and  pushes  

the  current  account  towards  deficit.    

Thus,  the  use  of  fiscal  policy  to  counteract  a  shortfall  in  mining  output  and  

investment  is  inadvisable.    The  Mundell-­‐Fleming  model  suggests  that  fiscal  policy  

is  less  effective  than  monetary  policy  in  achieving  short-­‐term  output  and  

employment  objectives.    The  exchange  rate  effects  associated  with  an  increase  in  

government  spending  will  only  impede  the  recovery  of  our  lagging  export  

industries.    

Furthermore,  falling  tax  receipts  from  the  mining  sector  and  an  increasingly  

precarious  budget  position  reinforce  the  need  for  fiscal  restraint.    Government  

spending  is  projected  to  exceed  30  per  cent  of  GDP  by  2055,  with  net  debt  to  

approach  60  per  cent  of  GDP  under  currently  legislated  policy  (Commonwealth  

of  Australia,  2015,  p.  46).    Australia  can  ill  afford  large  budget  and  current  

account  deficits  in  a  period  of  moderating  economic  growth  (Garnaut,  2013,  p.  

96).    Again,  the  accumulation  of  debt  restricts  our  ability  to  respond  to  future  

economic  shocks.  

     

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In  the  long  term,  policies  to  achieve  per-­‐capita  income  growth  must  focus  on  

improving  our  productivity.    The  maintenance  of  flexible  and  efficient  market  

institutions  allows  factors  of  production  to  be  allocated  to  their  highest  value  

use,  regardless  of  commodity  price  movements.    Low  trade  barriers,  minimal  

industry  protection,  strong  competition  regulation  and  a  robust  productivity  

agenda  will  ensure  our  continued  international  competitiveness  (Minifie  et  al.  

2013,  p.  46).  

In  summary,  the  Australian  economy  has  undergone  significant  structural  

adjustment  to  increase  mining  sector  output  over  the  last  decade,  but  this  

process  will  reverse  as  commodity  prices  trend  lower.    A  real  exchange  rate  

depreciation  will  assist  the  recovery  of  our  trade-­‐exposed  industries  and  achieve  

a  more  balanced  profile  for  future  economic  growth.    Monetary  policy  is  the  

preferred  instrument  to  facilitate  this  transition  and  support  full-­‐employment,  

although  much  of  the  adjustment  process  will  occur  autonomously  through  

existing  institutional  settings.  

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

       

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Figure  1:    RBA  Index  of  Commodity  Prices  

 Source:    RBA,  2015  

 

 

Figure  2:    Bulk  Commodity  Prices    

 Source:    RBA,  2015  

     

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           Figure  3:    Industry  Share  of  Business  Investment  

 Source:    RBA,  2015  

 

Figure  4:    Production  of  Key  Australian  Resource  Exports    

Iron  Ore         Liquefied  Natural  Gas  

   

               Thermal  Coal              Metallurgical  Coal  

   

Source:    Department  of  Industry  &  Science,  2015  

       

  10  

Figure  5:  Mining  Sector  Capital  Expenditure    

 Source:    Department  of  Industry  &  Science,  2015,  p.  9  

     

Figure  6:    Total  Mining  Sector  Employment    

 Source:    Department  of  Industry  &  Science,  2015,  p.  9  

 

         

       

  11  

Figure  7:    Effects  of  the  Mining  Boom  on  Industry  Output      

 Source:    Downes,  Hanslow  &  Tulip,  2014,  p.  23  

   

Figure  8:  Australia’s  Terms  of  Trade      

 Source:    RBA,  2015  

     

  12  

Figure  9:    Australian  Dollar  Against  Trade  Weighted  Index  

 Source:    RBA,  2015  

       

   

         

                     

 

 

     

  13  

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