Double Trouble

Two economies in the Asia-Pacific region look as though they could suffer especially severely from global events. Neither gets much mention in a media which tends to view manufactured exporters like Korea as particularly vulnerable to a sharp downturn in the west, and the United States in particular.

But there is a strong argument that India and Australia are, for different reasons, quite exposed despite claims by many local commentators that they are relatively well protected. Take Australia. Some are crowing that in August it had an A$1.3 billion trade surplus thanks to soaring coal and iron ore prices. The Australian Bureau of Agricultural and Resource Economics (ABARE) commodity export bureau has recently forecast that commodity exports will rise by A$65 billion this year (ending June 2009) led by mineral exports increasing by 53 per cent to A$180 billion.

Even assuming a steep rise in imports, Australia could look forward to its current account deficit perhaps halving to a manageable 2-3 per cent of GDP level from the 4-6 per cent of recent years when easy money and liquid international markets made deficit financing so easy that almost no one noticed and the Australian dollar went from strength to strength on the back of high interest rates and rising commodity prices.

However, the ABARE forecast seems to have been prepared in the happier times before Chinese buyers started to renege on orders for iron ore from India, or demand a renegotiation of the price. This is not to imply that China itself is about to go into a steep downturn, but simply that users were caught up in over-ordering at the height of the commodity boom. The spot price of iron ore in China and India has fallen from a peak of US$190 a ton to around US$120. That is still higher than a year ago, but is a huge fall in expectations. Australians may think that they are protected by the new long term supply agreements that they, and Brazil, concluded merely weeks ago with Chinese buyers. Forget it.

It is only a matter of time before Chinese mills demand – and get – big price concessions for iron ore and coal. Australia’s one hope for achieving sustained export growth lies in volume, particularly of coal, iron ore and gas. The latter may be safe enough, as is gold, but the additional supply coming on stream from iron ore miners Fortescue suggests that the price cycle downturn will be accelerated. Base metals such as copper and nickel have fallen sharply and although farm prices may be more resilient, much depends on the rain.

The improving terms of trade – a 60 per cent rise in five years – which have long buoyed the Australian economy have already begun to reverse, with export prices peaking out and import prices rising as the Australian dollar goes into reverse against almost all of its supplier countries.

This is serious for several reasons. Most immediately, Australian banks rely heavily on foreign borrowings which need to be rolled over. Even assuming that the global credit situation is eased as a result of moves in the US and Europe, the cost of funds is likely to stay relatively high at a time when bank loans losses in Australia have been rising. Antipodean households are, like those in the US and UK, excessively indebted, particularly for housing. Although the regulatory environment is much superior, it is hard to imagine that housing prices will not continue to fall for some time. The economy has been a two-tier affair for some time, with the urban east under strain while the mining dependent regions have been booming from high prices and new investment. But the boom is likely to end well before the urban east has hit bottom.

With small foreign exchange reserves and a robust determination to accept currency gyrations as a fact of life, the Reserve bank will do little to cushion the further falls in the Australian dollar as terms of trade decline and the real cost of servicing a massive foreign debt load rises. Even if the current account does shrink to 2 per cent of GDP, that still means some big financing at a time of tightening global money and possible disillusion by Japanese investors who have been major buyers of high-yielding Australian debt. An Australian dollar worth just 65 US cents and 55 Yen is quite on the cards before 2009 is over.

At first sight India looks very different. It has low exposure to international trade and foreign exchange reserves of US$300 billion, which would seem to underwrite a sustained period of domestic demand-driven growth. The “India-shining” commentators have been assuring the world that the country is safe. But there are several reasons for thinking otherwise. Firstly, though oil prices have fallen from their peak they remain at a level which is very uncomfortable for an economy expecting and needing continued big rises in energy consumption. Secondly, the iron ore export bonanza (its exports to China consist mainly of iron ore and other commodities) has come to a halt and may well go into reverse. Thirdly, reserves could dwindle rapidly if deposits by NRIs and others taking advantage of high interest rates are withdrawn in large quantities. Fourthly, the breakneck expansion of the past 2-3 years by major Indian firms has been partly based on borrowing abroad as well as at home. Domestic borrowing was slowing already and with public sector deficit remaining very high there is limited scope for private borrowers.

Now the global crisis is also beginning to expose the follies of groups like Tata using borrowed money, or issuing shares, to buy (at extravagant prices) trophy properties abroad (Corus, Jaguar, etc). Such deals could now have a serious impact on perceived Indian creditworthiness, and limit firms’ abilities to invest in the country itself. It always did seem bizarre that Tata bought a huge European steel company when India’s own steel output is one tenth that of China.

Nor is India quite as detached from the global economy as is often assumed. Its most dynamic parts are indeed closely connected, notably the software and business process outsourcing which are so important to its balance of payments. A significant part of that is for the financial services sector in America and Europe now in the process of a rapid contraction. Worker remittance flows will also be affected in time as the madcap building boom in the Gulf states abates.

None of this is to suggest that India faces a major disaster. Even under the worst circumstances growth looks unlikely to fall to what used, in the bad old days of the licence raj, to be the norm – 3.5 per cent. Agriculture, population and the natural ebullience of consumer demand will all keep it relatively buoyant. But it is a myth to suppose that it will only be lightly affected – or that that stock market valuations have adjusted to today’s realities. At an index level of around 13,000, the stock market index may be 37 per cent down from its all time high in January, but it is still nearly three times its level of five years ago.