An ill wind

Treasurer Jim Chalmers may talk about the tough times that Australia confronts, but the fine print of his budget papers reveals the extraordinary bounty which the global energy crisis is delivering to the federal budget and the Australian economy at large.

Since the budget handed down by the previous government in March, Treasury has upgraded its estimates of the revenue that the government will receive this year by an extraordinary $57.3 billion, thanks to unanticipated improvements in the economy. Most of this comes from higher company taxes generated by resource exports.

What makes this all the more remarkable is that in that last budget, only seven months ago, Treasury had already upgraded its estimates of revenue this year by $39.5 billion from the estimate it made four months previously in the budget update released in December last year.

That mid-year update had itself added $21.6 billion to the revenue forecast made in the May budget last year. And, you guessed it, last year’s budget had already upgraded its estimate of 2022–23 revenue by $19.4 billion.

These are all described in the budget papers as ‘parameter variations’ and reflect improvements in the economy—mostly higher commodity prices—rather than government decisions.

Adding it up, the cumulative improvement in budget revenue this year is a phenomenal $137.8 billion or about 22% since the end of 2020. True, this followed what proved to be unduly pessimistic forecasts for the impact of Covid-19 in 2020, but total revenue this year is still expected to be $68 billion or 12.6% ahead of what Treasury anticipated in December 2019, before the pandemic.

Not many countries enjoy this kind of bonanza, handed to them on a plate. For most countries, the prices they receive for their exports are much the same from one year to the next. The price of nearly everything is going up at the moment, but, in general, the prices of manufactured goods and services are not subject to big swings between boom and bust, as are commodities.

For most countries, improvements in the returns they get from their exports, relative to what they must pay for their imports, have to come from gains in productivity. Countries (and companies) can only achieve greater profits from their exports if they achieve greater efficiency.

Improvements in productivity are hard won: gains of 1% or 2% a year are about as much as can be expected in a well-performing economy. Over the past five years, Australia’s productivity performance (using the broadest measure of productivity) has been a dismal 0.35% growth a year, but average export prices have more than doubled in this time.

The spiralling price of energy may be a crisis for households and manufacturers around the world, but it is a windfall for energy exporters. Among the handful of significant economies in this fortunate position are the United States, Russia, Saudi Arabia and Norway.

The breakdown of relations among this foursome is a large part of the reason why energy prices are soaring. Russia has unilaterally cut exports of gas to Europe, while the US and Europe, along with much of the advanced world, are imposing economic sanctions that affect Russia’s energy exports.

The US is trying to make the most of the shortfall in Russian supplies to the market by boosting its own shale-derived oil and gas exports. The US’s emergence as a net exporter of energy means it is a competitor of rather than a customer for Saudi Arabia, which is instead forging common cause with Russia. As for Norway—a founding NATO member—it is having to focus on the threat of sabotage to its energy infrastructure from its neighbour, Russia.

Australia sits gloriously remote from this miasma and has no geopolitical agenda. It is simply raking in the money. While China may order discriminatory bans on Australian commodities that are illegal under World Trade Organization rules, Australia has made no move to retaliate and is content to keep shipping as much liquefied natural gas, iron ore and any other commodities that China will accept as it can.

No other economy has had such a sustained run of good fortune as Australia. It has enabled governments to introduce the National Disability Insurance Scheme, increase aged care funding, boost the share of GDP spent on defence to 2% and cut taxes. There are inevitably calls for the government to spend yet more, but there is danger ahead.

The key economic measure is the ‘terms of trade’, which compares the price received for exports with the price paid for imports. It is measured as an index. A rising terms of trade adds to national income.

For most of Australia’s history, the index measure has hovered at around 60 points. There have been brief spikes to 70 or 80 points, during the nickel boom in the 1960s and through the commodity boom that accompanied the oil crisis in the early 1970s. There was a slump to around 50 points in 1986–87—when then-treasurer Paul Keating proclaimed that Australia would become a ‘banana republic’ unless it tackled its balance-of-payments deficit.

But starting in the early 2000s, the terms of trade started climbing to unprecedented heights, as Australia became the supplier of choice for the extraordinarily resource-intensive burst of growth in China.

The terms of trade surpassed 100 points in 2008, as the resource boom peaked ahead of the global financial crisis, and then rose further to reach 120 points in 2011. It slipped back to 80 points by 2016, but has since zoomed back past 120 points, or around double the long-term average.

To get a sense of what that means in dollars, Australia’s exports in the past 12 months were $550 billion. If the terms of trade index went back to its long-term average, that would strip about $275 billion of annual income out of the economy. The federal budget would lose around $90 billion.

How likely is that? Treasury is in fact forecasting a big fall in Australia’s export commodity prices. By March next year, it assumes prices for a tonne of iron ore will drop from US$91 to US$55, for steel-making coal from US$271 to US$130, for thermal coal (for power stations) from a hard-to-believe current price of US$438 to US$60 and for LNG from US$934 to US$630.

The budget anticipates the terms of trade dropping back to around 95 points next year. That’s still about 50% higher than the long-term average. Treasury comments that the war in Ukraine may prolong the boom in energy prices while the downturn in China may depress iron ore prices.

Historically, the terms of trade has always reverted to somewhere around its long-term average of 60 points. Until the China boom came along in the early 2000s, it was often said that Australia’s terms of trade was destined for a long-term decline.

As mining became more capital intensive, costs per tonne would fall and prices would follow. On the other hand, it was expected that an increasing share of income would be spent on ever more sophisticated and expensive manufactured goods and high-cost services.

The China boom turned that logic on its head—the world did not have enough resources readily available to meet China’s ravenous demand, so more marginal and higher cost resources had to be tapped, pushing resource prices higher across the board. China’s unrivalled scale, on the other hand, meant the cost of manufactured goods fell.

It’s too soon to say definitively that the China boom is over, but it looks entirely possible, as the property boom that fuelled its meteoric growth deflates. There’s a risk that Australia’s terms of trade will drop back towards its long-term average, with the prices of the commodities we export returning to their traditional relationship with the manufactured goods we import.

Geopolitics may keep energy prices higher for longer, but there would be a hangover and some very hard decisions if the Chinese punchbowl were whisked away.

This article was published by The Strategist.