The Lucky Country's Fuse Burns Out

"So if ever there was a sell in sight it is the Aussie at 90 cents, and shares in the self-congratulatory Aussie banks" – Asia Sentinel, 12 May 2010

Since we advised hardly three weeks ago of the danger of investing in either Aussie dollars or Aussie banks, both have fallen out of bed – and look to fall further as the investment community finally seems to be waking up to the extent of Australia's debts and the vulnerability of its household sector – and hence by extension the banks.

Since we wrote, the share prices of the largest banks, Westpac and National Australia Bank, have tumbled by some 20 percent and the currency has fallen from 90 cents to the US to just 82. A drop back to 75 looks on the cards soon and perhaps back down over the next few months to the 55 it hit in late 2008 at the height of the global financial panic.

Further still down the track it could look to test the 48 cents nadir of 2002, before commodity prices started their five-year boom which has given Australia unprecedented gains of almost 50 percent in its terms of trade. Yet despite this bonanza, the current account remains in deficit to the tune of 4-5 percent of GDP. Australia likes to think of itself as a developing country which needs capital. But it is a mature economy which if doesn't watch out could one day go the way of Argentina, which a century ago shared with Australia the distinction of being the world's richest nation per capita.

This time around, the bottom does not seem likely to fall out of commodity prices quite yet. But who knows how much of Chinese buying, particularly of iron ore, has been stimulated by a mix of cheap money encouraging stockpiling and an unrepeatable surge in spending on heavy infrastructure products which may have scant economic return but are huge consumers of steel? Even now, Chinese planners may be having second thoughts about, for example, spending trillions of yuan on high speed railways which few can afford and which cost a mint to run. China's urbanization rate is also slowing thanks to its demographics.

This time around the commodity bust impact on the Aussie dollar could be even greater because of the increase in net foreign debt from A$330 billion in 2002 to A$650 billion now. As a proportion of GDP it has risen from 35 percent to 50 percent. The Reserve Bank of Australia may well want to engineer a further sharp currency decline. Australia after all is well accustomed to a volatile exchange rate and unlikely to panic when it happens. But some people, somewhere will have to bear the tens of billions of dollars cost of the increased local currency value of the 55 percent of the foreign debt which is not denominated in local currency. How well spread that will be has yet to be determined.

Meanwhile Australia's inward-looking markets and commentators are tending to blame much of the stock and currency falls on the Rudd Labor government's promise/threat of a resources tax which would tax profits above the government bond yield benchmark as cost- of-capital level at 40 percent. In response mining groups big and small have announced freezes on their investment plans.

Debate on the subject has been extremely partisan and couched more in political than pragmatic terms of aiming to maximize the growth of the industry with maximising returns to the nation from its natural resources.

The Rudd government's timing has been particularly unfortunate, coming as it did on the eve of a sharp correction in mineral prices which probably has further to run. However, Rudd may have been doing the miners a favour by giving them cover for putting on hold some massive projects which might not turn out to be viable anyway. Or, if they were completed, would worsen oversupply situations and return prices to the levels in real terms they faced in the decade and a half to 2002.

The long lead times in new mining ventures make estimates of future prices extraordinarily difficult. That is particularly the case for the likes of iron ore, which has massive up-front costs but very low marginal operating costs per ton.

The miners must also face the fact that exponential growth in Chinese, Indian and other developing country demand may not continue. Or that the shale gas boom now spreading from the US to Europe and China could kill off many of the profit expectations of Australia's offshore gas fields, which are huge but have massive capital costs.