Given the mining sector’s explosive growth in recent times, I’d like to highlight a report two of my colleagues penned. It gives interesting insight into the sector and its reach on the greater Aussie economy.

Collateral damage: the industry fall-out from the mining boom’s impact on the dollar and relative prices.

By Kieran Davies and Felicity Emmett from RBS.

Overview

Australia’s mining boom is already the largest in more than a century, with higher prices seeing incomes grow at a 10 per cent rate, just behind China. Higher commodity prices have underpinned the highest real exchange rate since the mid 1980s. The currency has a modest and drawn-out effect on inflation, but it is hard to identify a reliable impact on overall growth.

Our sectoral analysis reinforces this view, as we estimate that three-quarters of the economy is unaffected by the currency, with only a handful of industries influenced by the dollar, with tourism most at risk. Even so, the mining boom is still a huge relative price shock to the economy, with the doubling of mining prices attracting more resources to the sector from the rest of the economy. On our calculation, farming, IT/media and retail are most exposed to this massive shift in relative prices, with real estate services, finance and education least affected. With the mining boom likely to have a long life as China continues to catch up with the west, this major structural change is best addressed by Government, with interest rates better aimed at inflation risks from the boom.

Mining is experiencing its biggest boom in over a century. 

The driving force of the economy over recent years has been the resources boom, which took a step backwards during the global financial crisis, but is back in full flight thanks to surging iron ore and coal prices, with gas rapidly growing in importance.

With the boom, we estimate that the mining sector now accounts for about 11 per cent of GDP. This is almost double the share reached during the late 1970s/early 1980s energy-led mining boom and matches the peak reached more than a century ago during the late 1890s gold boom. While massive, the current boom still pales in comparison with the 1850s gold rush.

As a result, Australia’s income is growing almost as fast as China’s.

The most obvious impact of the boom is the huge boost to incomes, with Australia’s nominal GDP back growing at a double-digit rate, up 10 per cent over the past year. This is very rapid growth by past standards and globally it places Australia just behind China!

Higher commodity prices have underpinned a higher real exchange rate.

Driving the boost to incomes is the surge in the terms of trade (that is, the ratio of export to import prices), which has reached its highest level since the 1950s (back then, commodity prices reached a short-lived record high due to the demand for wool because of the Korean War). In turn, high interest rates and the high terms of trade have lifted the real exchange rate to its highest level since the mid 1980s, not long after the dollar was floated. 

The currency has a modest impact on inflation, but it is tough to see a reliable link with activity.

Our work on modelling consumer prices shows that the higher currency has a modest, drawn-out impact on inflation and it seems natural to think that the currency should also affect activity in the economy. However, our recent analysis showed that it was hard to find a reliable link between the real exchange rate and overall growth. This means that it is difficult to pin down the trade-off between the currency and interest rates that is traditionally embodied in monetary conditions indexes, although if you torture the data long enough you can recover a rough ratio of five or six to one (that is, a five to six per cent change in the real exchange rate has broadly the same impact on growth as a one percentage point increase in the real cash rate).

It seems that the impact of the currency on different industries is limited and patchy.

While it is hard to identify a robust relationship between the real exchange rate and overall growth, the higher exchange rate could still cause problems for some industries.

To see if this was the case, we looked at the impact of the real exchange rate on growth by industry across the economy. We looked at this a couple of different ways, estimating simple single equations for each industry, as well as testing whether the real exchange rate helped predict growth in a VAR model for each sector.

The period we looked at was from 1993 onwards, which was when the Reserve Bank introduced its inflation target.

The results suggested that the real exchange rate had little or no impact on most industries (totalling about 75 per cent of GDP). For six industries, worth a total of about one-quarter of GDP, there was an effect, although it was marginal for three sectors and had an unusual sign in three cases (that is, a higher real exchange rate had an unexpectedly positive impact on growth).

Looking at the industries in detail:

1. The relationship between the real exchange rate and the manufacturing sector looks to be spurious given that, contrary to expectations, thecoefficient is positive, whereas instinctively it should be negative.

2. The loose relationship between utilities and the exchange rate seems slightly more intuitive, although the fit is not close. Given that utilities generally track the broader economy it is perhaps signalling something of a whole economy impact that our earlier work failed to pick up.

3. The relationship between wholesale trade and the exchange rate is difficult to detect from the chart below, although the coefficient is negative as one would expect.

4. The accommodation, cafes and restaurants sector does seem to have quite a good relationship with the real exchange rate, showing clearly correlated peaks and troughs. This likely reflects the sensitivity of tourism, both offshore and domestic, to the exchange rate.

5. The transport sector looks to have quite close relationship with the real exchange rate, although given that the coefficient is negative it seems likely that the relationship is spurious.

6. The relationship between the rental, hiring and real estate services sector and the real exchange rate is particularly loose, and the positive coefficient seems odd.

The limited and patchy sectoral impact of the real exchange rate is disappointing, but chimes with our earlier work that found it difficult to identify a useful link between the currency and the whole economy.

Nonetheless, the mining boom is still a huge relative price shock to the economy.

Nevertheless, the mining boom still represents a huge internal shock to the economy via its impact on relative prices that greatly favours a reallocation of resources away from the rest of the economy towards the mining sector.

That is, according to our crude calculations, mining prices have roughly doubled since the start of the resources boom in 2003, which dwarfs the 20 per cent gain seen in the rest of the economy.

This huge relative price shock is more a problem for some industries than others.

To get a sense of which industries are most affected by this massive relative price shock, we looked at the gain in prices by sector since the start of the resources boom.

The comparison didn’t include the past year’s rise in prices because we didn’t have the data for every sector outside mining, but it was still interesting to see that:

1. Farming and the IT/media sectors had no price growth over the period and hence face the biggest relative shock. Retail is the sector next most exposed, followed by utilities, construction, manufacturing, admin and professional services.

2. At the other end of the spectrum, the sectors that had the biggest price gains over recent years and hence are least exposed to the relative price shock are real estate services, finance, education and accommodation.

The relative price shock will attract more resources towards mining and is best dealt with by Government rather than interest rates.

Assuming that this relative price dispersion continues, then this suggests that farming, IT/media and retail sectors will be at the pointy end of the strains caused by the strength of the mining boom. At the other end of the scale, real estate, finance, education and accommodation sectors should be least affected.

Given the sheer scale of the mining boom and its likely long life, this structural change is likely to be significant and persistent, a point the Reserve Bank has made, but seems better addressed by Government rather than interest rates, which should continue to be aimed at the inflation risks from mining boom.

Important information:This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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