Sunday, October 12, 2008

Commodities could topple our domino

The world economy looks like a set of falling dominoes at the moment.

What started out as solvency problems in the subprime mortgage market has spread throughout the United States.  Asset write-downs and credit losses for banks, combined with tighter credit for small and large businesses alike, has lead to fears of recession in the world's largest economy.

Some of Europe's dominoes have also fallen, as a lack of liquidity translates into slower economic activity.

The International Monetary Fund predicts a sharp fall in economic growth for the Euro area in 2008 and 2009 compared to last year.  As in the US, governments in Germany, Greece, Iceland, Ireland and Spain and the UK are bailing out financial institutions using taxpayers' money.

So far, the Australian economic domino has remained largely unscathed from the fallen heap around it.  While national growth is predicted to moderate,and business and consumer sentiment has weakened this year, our financial system remains strong in the midst of some perilous international
conditions.

Strong global demand for Australia's commodity bounty over the past few years has fuelled exports as well as our incomes.  With almost half of Australia's coal exports alone mined in the Hunter Valley Region, and shipped out from an increasingly busy Port of Newcastle, the local region has been at the forefront of our national prosperity.

The local economic good times have been driven by Asian economies, especially China, needing our resources to help them grow.  It should also be remembered that Australia was growing at a healthy rate before the current commodities boom.

Yet, as is the case of the current domino dynamic of world economies, there are some hints that Chinese growth is slowing.  There are reports that slowing demand and tighter lending by banks are forcing Chinese purchasers of commodities to delay their shipment orders.  It is predicted that
coal and iron ore prices could fall by as much as 20 per cent next year.

Other factors point to a Chinese economic slowdown.  Subdued growth in America will surely affect China's export incomes, as will concerns about quality standards of Chinese merchandise sold overseas such as toys, paint and confectionary.

What might happen to our economy if the Chinese domino either falls or teeters about precariously?

For a start, there could be some local impacts.  Falling demand by the Chinese for Newcastle's coal and iron ore may, at the very least, dampen growth in local employment and business investment.  It could raise new questions about the economic viability of major projects such as the mooted expansion of the Port of Newcastle.

The ramifications of a China slowdown could branch out across the national economy.  It is estimated that a 20 per cent reduction in iron ore and coal prices could lower Australia's annual export earnings by some $20 billion.  The resource rich states of Western Australia and Queensland could be particularly affected.

Changes in China's economic outlook could affect the state budget.  On the tax side, mineral royalty payments could fall, as well as taxes sensitive to economic activities including payroll tax, stamp duties and motor vehicle taxes.  GST revenues, passed onfrom the Federal Government, could also fall if consumers spend less in a slowing national economy.

Without any cutbacks to government spending, falls in revenues could further erode an already diabolical state budget position.  The failure of the Carr, Iemma and Rees Labor governments to reduce excessive public spending in the good years means that the "fiscal crunch" from a slowing China would be a tortuous one.  The Rudd Labor Government is not immune from the potential impact of a China slowdown either.

Despite its assurances about a strong budget surplus, the take from federal income taxesand other levies could nonetheless decline.  This would place upward pressure on interest rates, and put in doubt big-ticket spending items such as the proposed $20 billion splurge on state infrastructure projects.  In a globalised world, it pays to carefully watch the ebbs and flows of economic conditions abroad and to act appropriately.

Consumers and businesses are already doing so, by way of tightening their belts during a time of economic uncertainty.  The key question is whether governments will follow suit by paring back the spending churn and waste of recent years.

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