Ausbuy

Australia, Mining and The Dutch Disease

July 22nd, 2007

Is the current mining boom in Australia’s best long term interest? Certainly many people, particularly politicians and investors, like the short term effects. The country’s budget is in surplus and share prices are rising. These outcomes are unarguable, but what about the long term effects? Before we look at Australia, we should consider the Dutch Disease.

Wikipedia defines the Dutch Disease as an economic concept that tries to explain the seeming relationship between the exploitation of natural resources and a decline in the manufacturing sector. The phrase was coined by the economist to describe the decline of the manufacturing sector in the Netherlands after the discovery of natural gas in the 1960’s. Resources, investment and labour were drawn into the boom sector, and the comparatively less profitable manufacturing sector neglected. At the same time, the currency appreciated making exports uncompetitive and attracting imports. Under these twin pressures manufacturing capacity declined. As the natural gas ran down people belatedly realised that manufacturing capacity once lost, is very difficult to regain.

The Netherlands in the sixties has a very strong resemblance to the Australia of today. In Australia money is being poured into the development of new mines and the Stock Exchange is establishing new records on a regular basis. At the same time, manufacturing companies are transferring their production capacity offshore. Hard earned skills are being dissipated, and new entrants are not being trained in the skills required to run a modern factory. Like the Kroner, the Australian Dollar has appreciated. In the case of Australia, a ridiculous appreciation of 75% over 5 years has, not only led to a decline in manufacturing, but has also made services in such areas as tourism and education supplied by Australia, a high priced option.

One of the problems in life is that all booms come to an end. In the case of The Netherlands, we can see what happened when the music stopped. During the boom a complacent government bought popularity by having an unsustainable level of spending on social services, but the private sector had not been prepared to spend on the technological development required to sustain a viable manufacturing industry. Investing in infrastructure was concentrated on the sectors supporting the boom. In the seventies the gas started to run out, but by this time the manufacturing capacity had decreased and public spending was out of control.

Australia is currently enjoying the benefits of the boom. An overvalued currency is helping to control inflation by sucking in cheap imports, and the Federal Government is running a budget surplus on the back of rising company profits. The only thing missing was expenditure on boom-related infrastructure. Despite the boom, the Trade Deficit continues to grow as the public use an overvalued currency and easy access to credit to spend on imported luxuries and overseas holidays. The tendency to spend is being reinforced by the Stock Exchange, which is being valued on ever higher PE ratios and rewarding investors with paper profits.

Now let us look at what could happen when the boom comes to an end:

• The PE ratios used to value shares will drop and with them much of the paper profits.
• Interest rates will increase to control spending habits.
• The currency will drop and inflation will increase with the cost of imports being paid for by a lower A$.
• The Balance of Trade will deteriorate further until the demand of the Australia economy contracts.
• The overall standard of living will drop.

The only change which will not take place is a rapid resurgence of the Australia manufacturing industry. The intellectual and technological capital dissipated during the boom is not easily replaced.

Australia should recognise that all booms are transient and plan for the day when it starts to come to an end. Unfortunately many of the steps are politically unpopular as the media call for more and more welfare spending and the banks make money easily available for consumer spending.

I would conclude by saying that the current boom is a mixed blessing which will require careful handling.

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