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Published 13 September 2012 05:01, Updated 13 September 2012 10:43
Trying to work out where the iron ore price will go is anyone’s guess. Much of the recent fall has been exaggerated by destocking in the face of softer than expected steel demand and it’s a reasonable bet that once destocking has run its course – and with high-cost suppliers cutting production – the price will stabilise and recover, maybe towards $US100 ($97.70) a tonne next year, as China’s growth rate stabilises.
While our base case sees a reasonable outcome for the Australian economy, albeit weaker than the Reserve Bank and government are assuming, the slump in the iron ore price poses a significant short-term risk for the Australian economy, particularly if the slide continues. This brings us to an alternative scenario worth considering.
The scenario has four elements:
First, a continuing slump in the iron ore price could bring forward the peak in mining investment to early next year from 2014 as a cash flow crunch in response to falling iron ore prices and hefty capital spending forces miners to slash current investment. With an earlier timing of the peak, other sectors may not be in a position to fill the breach.
Second, the associated sharp fall in the iron ore price would lead to a loss of national income, job losses and reduced tax revenue for state and federal governments, possibly triggering further fiscal tightening.
Third, rising unemployment could trigger increased mortgage delinquency and hence a collapse in house prices at a time when house price-to-rent and price-to-income ratios remain high by global standards as home owners struggle to service their loans amid job losses.
Finally, rising mortgage defaults could trigger problems for banks at a time when they would also struggle to fund themselves, further reinforcing the economic downturn and possibly requiring public assistance in the form of a recapitalisation and funding help.
Such a scenario is doing the rounds (again) from foreign commentators. Having observed for years that the combination of excessive house prices and its counterpart of excessive household debt amounts to Australia’s Achilles heal, with the key trigger for problems being a collapse in the terms of trade, I cannot completely dismiss such a scenario. However, there are several good reasons why I think it is unlikely.
First, while overvaluation suggests the risk of a house price collapse, it is offset by significant under-building and under-supply, low loan-to-valuation ratios, the absence of any deterioration in lending quality and full recourse loans in Australia. The most likely scenario for house prices remains an extended period of range-bound prices in real terms.
Second, if house prices don’t crash the risk for banks is far less – in any case they are already less reliant on non-deposit funding. Even if funding did become difficult again it would be easy to reintroduce the government guarantee for bank borrowing.
Thirdly, some seem to think that as the mining sector has been a key driver of Australian growth recently, once it goes there will be nothing to replace it. In reality the past few years amounted to a structural adjustment constraining growth elsewhere in the economy via high interest rates and the Australian dollar to allow the mining investment boom to occur without overheating the economy. If the mining investment boom evaporates, the non-mining economy can pick up again – for example, housing investment where there has long been an undersupply relative to demand.
Finally, Australia possesses significant shock absorbers. Interest rates are still a long way from zero. And the Aussie can fall a long way – to US60¢ as it did in 2008 – to help boost growth. This makes Australia very different to euro zone economies, where there has been no currency relief.
The risk is certainly there and cannot be ignored. The best way to minimise it, though, would be for the RBA to aggressively cut interest rates.