Why Australia’s luck is set to run out

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published 9 June 2022

On 21 May, Australia went to the polls. The incumbent prime minister and leader of the centre-right Liberal Party Scott Morrison sought to win a consecutive fourth term in office. Late on election night, Morrison conceded and on 23 May Anthony Albanese, leader of the centre-left Labor Party, was sworn in as prime minister. But Albanese’s victory may be a Pyrrhic one.

Labor’s election looks very much like a decision to kick out the other guy. Much of the debate was thin on policy discussion and heavy on personalised attacks on the likeability of the incumbent prime minister. Labor enters government with a narrow outright majority, but more of a wish list than a strategy. For example, Albanese has promised increased healthcare spending, increased education spending, increased childcare spending, and to promote renewables. He has also promised to give unions more power via laws criminalising “wage theft” and a commitment to reducing carbon emissions by 43% by 2030.

Australia has historically often delivered good returns for investors. In the ten years to the end of May, the MSCI Australia had an average total return of 9.3% per year in sterling terms, ahead of the UK (7.6%) although well behind the US (16.6%) like almost all markets. Over the previous decade – when the commodity boom was in full flow – Australia returned 11.8% per year, while the UK delivered 4% and the US returned 3.75%. So any investors who think another commodity super-cycle is getting under way may be tempted to back that view by buying Australian assets. Yet the case for doing so this time is weaker than before, in part due to the lack of positive politics at a time when Australia faces some of the most difficult problems it has faced as a nation since the Second World War.

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Geopolitical tensions are running high after the Russian invasion of Ukraine, and those tensions are quickly spilling over into the South China Sea. It is not an exaggeration to say that the coming decade will define Australia’s place in the world for the lifetimes of all those who live today. The country is torn between its historical alliances and its new economic reliance on China. Public opinion on these matters is skittish and ill-formed and those who run the country have not articulated a clear strategy.

The Australian economy has always been a relatively small, open economy with extensive trade links. In the early 1960s, Australia traded with a diverse basket of countries, but the largest by share of exports were the United Kingdom (23.5%) and Japan (22.4%). These trade relations reflected Cold War realities. However, in the past three decades Australia has hugely increased its trade with China. In the early 1960s, China accounted for 7.7% of Australian exports. Today it accounts for 36.4%, dwarfing Australia’s second largest trade partner, Japan, which accounts for 10.7%. These new trade relations reflect the new reality in the region.

When we break down Australian exports to China there is little in the way of diversity. Iron ore makes up some 83%, with various other mining exports accounting for an additional 6%. These past few decades, Australia has effectively become China’s miner. The mining sector has given rise to other lucrative sectors in the Australian economy, most notably a thriving finance sector and an extremely active construction sector.

The construction sector has become particularly important to the Australian economy. Today it makes up roughly 60% of total capital formation in the economy. It derives its energy from a property market that is relentless in rising from peak to peak and leaves on its cliffs the corpses of those who predict that the bubble is soon to burst. Whether the property market in Australia is in a bubble or not, there is little doubt that it relies on the mining sector for its buoyancy.

The recent shifts in geopolitics threaten these cosy economic relationships. Since China’s accession to the World Trade Organisation in 2001, it has been assumed that the country would fit itself seamlessly into the global order. This line of argument was mainly to be found in Washington and in those capitals that tended to follow America’s lead. This narrative has now fallen out of favour, in favour of a competing narrative touting the dangers of China’s ascendency.

Many attribute this shift to former US president Donald Trump, but it began under his predecessor Barack Obama, who spent some of his childhood living with his Indonesian stepfather in Jakarta. Obama was conscious of China’s rise since the moment he set foot in the White House and announced a new Asia strategy in 2011 under the moniker “Pivot to Asia”. The pivot was designed to strengthen bilateral trade and security alliances in the region. While it purported to include China, many in Beijing were sceptical.

This strategy was turbocharged by Trump, who had stood on a platform that emphasised the negatives of shipping American manufacturing jobs to China in the 1990s and 2000s. The Trump administration completely failed to address the reshoring of American manufacturing in any meaningful way, but those in foreign policy circles who favoured a more aggressive stance vis-à-vis China seized on Trump’s rhetoric and relations deteriorated quickly.

Joe Biden’s policy in the region has become increasingly focused on China’s long-standing threat to invade Taiwan. This reflects the foreign policy failures that emerged under the Biden administration elsewhere in the world, notably the botched withdrawal of Afghanistan and the invasion of Ukraine by Vladimir Putin’s Russia. Taiwan has become a battleground for American pride at home and abroad. After the failure of American Middle Eastern policy and the failure of Nato policy in Eastern Europe, many in the US government appear to have drawn the line in East Asia.

This new geopolitical reality puts Australia in a tough spot. Australia has long been a solid ally of the US. Australian troops were some of the first to enter Iraq during the US-led invasion in 2003. Australia is also a prominent member of the Five Eyes alliance (with Canada, New Zealand, the UK, and the US) that shares intelligence. Yet Australia’s economy is now almost completely dependent on China. What is more, most Australians do not view China as a threat. Rather, they view it as either the source of the country’s wealth or a potential business partner. This is clear if you follow Australian popular media.

Toward the end of the Trump administration, Australia started to beef up its military defences in cooperation with the Americans. In a clip from an Australian political TV satire called Utopia, the heads of the Australian army are asking members of the government for a huge amount of new defence spending to counter the rise of China and protect Australian trade routes. After an awkward exchange, the prime minister says: “We’re spending close to $30bn a year to protect our trade routes with China, from China… and that doesn’t strike anyone at this table as odd?” This captures the general mood in Australia.

The military and security apparatus, due to their longstanding relationships with the US, feel obliged to sign on to US policy in the region. But since the economic relationship between Australia and China is so important, and since it would obviously not be in China’s self-interest to interfere with them, civilian leaders and the Australian people more generally have a hard time stomaching these geopolitical changes.

However, the Covid-19 outbreak has gone some way to change this. Lowy Institute polling shows that in 2016, 75% of Australians viewed China’s economic growth in a positive light. In 2021, that number had fallen to 47%. Yet this shift is in response to a once-in-a-lifetime crisis and it is by no means clear if these polling numbers can hold up. If they do and Australia take an overtly aggressive stance against China, it seems likely that Australian living standards will suffer as a result – especially with Russia now stepping up to provide China with raw materials.

A close look at the Australian macroeconomy shows an unusual country. Australia runs a relatively balanced trade account and has done so since the numbers start in the 1950s. Yet since around 1980 Australia has run current account deficits. The current account measures the total amount of money coming in and out of the country. So if the Australians run roughly balanced trade with the rest of the world, what accounts for all this money flowing out of the country?

When we dig into the statistics, we find that these are “rents” that the Australian economy is paying out to the rest of the world – interest rate payments and dividends on foreign-owned Australian debt and equities. In recent years, the equity component of this arrangement has declined and the debt component – especially, the long-term debt component – has increased. In the 2000s, roughly half these assets were owned by Britons and Americans. In the 2010s, Americans still held around 27%, but the British share fell from 24% to 18%. The rest did not flow to China, which owns few Australian assets (2%), but rather to European citizens. Australia is a country of foreign investment and in that sense, it is still a frontier country. Now we can see that the contradiction Australia is caught in becomes even more profound. The economy is tied to China while its military alliance is tied to the US and foreign-held wealth is mainly in the hands of countries that are also allied to the US militarily and strategically. This puts Australia in a very awkward position indeed.

For example, take Australia’s largest mining company, BHP. In the past five years, BHP has seen its stock price climb more than 90%. It has a relatively low price/earnings (p/e) ratio of just over ten and it pays robust dividends, so it currently yields just over 10%. This looks like a very attractive mining stock. But open its 2021 annual report and you find that 65% of its revenue comes from China. Put simply, the largest mining company in Australia’s stock market looks good based on the goods it sells to China, but remove these and it’s worth a lot less. For a counterpoint, consider that following the Russian invasion of Ukraine, we have seen just how sensitive mining stocks in geopolitically sensitive parts of the world can be. Polymetal, an Anglo-Russian miner, saw its stock fall more than 80% after the invasion.

What holds for Australian equities also holds for Australian debt. Moving forward, Australian debt will have to factor in geopolitical risk in the region. Meanwhile, the Australian government will have to walk a fine line between reassuring investors that nothing scary is going to happen at the same time as it assures its allies in the Anglosphere that it is committed to position the country against China if there is regional conflict. Investors in both equities and bonds also need to note that regional tension could be bearish for the Australian dollar.

Every country will have to deal with these problems except those that have managed to secure domestic food and energy supplies. However, Australia will be hit with additional problems. This is because the Australian dollar is a currency that is particularly sensitive to inflation, both domestic and global. Regression analysis suggests that changes in US and Australian inflation explain roughly 50% of moves between the US dollar and the Australian dollar. More inflation in either the US or Australia means a lower Australian dollar.

This poses several problems for the country. First, if a currency is sensitive to inflation and a country has a large number of imports, inflation can feed on itself. The currency will fall, raising the price of the imports. These prices are passed through to consumers, inflation rises higher, and the currency falls more. Australian imports clock in at 20% of GDP – not as high as the UK’s 28% but higher than the US at 13%.

Secondly, a decline in the Australian dollar would erode the value of Australian debt held abroad. This would make it less attractive for investors to engage in debt-financed foreign investment in Australia. If foreign investment were to fall, a key source of Australia’s frontier growth model would be challenged. Finally, a declining Australian dollar would make foreign investment in Australia’s property market less attractive. Reserve Bank of Australia data suggests this sort of investment only makes up about 5%-10% of total investment. But if the mood starts to turn sour, an exodus of foreign property investors could rattle nerves.

Are we to conclude that Australia’s future is inevitably so grim? Not necessarily, but we must acknowledge that Australia currently seems caught between a rock and a hard place. Its historical alliances, cultural and strategic, are pulling in one direction, and its economic interests are pulling in another. This is not a place any country wants to be in. However, this future is not set in stone. If Australia play its cards right, it might be able to stay both friendly and prosperous.

Obviously, peace is in the interest of Australia. Conflict over Taiwan would almost certainly force it to choose sides, so ensuring that this conflict does not happen should be its top international priority. There is no simple way to do this, but the country will need to brush up on its diplomatic skills. It should certainly not simply subordinate its economic interests to the geopolitical interests of its allies.

However, investors today are already thinking a lot about geopolitical risk. After the wide range of ruptures in the wake of the Russian invasion of Ukraine, markets are waking up to the fact that trade flows do not happen without the consent of both parties. Even financial systems are not guaranteed to work smoothly if tensions reach a certain pitch. Moving forward, investors will have to take geopolitical risk in Australian markets very seriously indeed. They cannot assume that the “lucky country” can continue getting by on luck alone.

One troublesome feature about geopolitical risk is that it places a lot of influence in the hands of politicians. In normal circumstances politicians – thankfully – have a limited impact on market outcomes. But when geopolitical risk is on the table, one bad move by a government and its civil servants could result in major market moves that might not be reversed for years. If nothing else, investors who have large holdings in Australia will want to familiarise themselves with the politics of Australia and how its leaders think. Doing so might not just save you from losing your shirt, but it may even throw up interesting bargains down the line.

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Philip Pilkington is a macroeconomist and investment professional. He is the author of the book The Reformation in Economics, and blogs at Fixing the Economists and on Twitter @philippilk