China’s China’s resources resources needs needs and and Australia’s Australia’s resource resource trade trade Presentation to

Australia-China Business Council Saul Eslake Chief Economist ANZ

Intercontinental Hotel Beijing 23rd October 2006

www.anz.com/go/economics www.anz.com/go/economics

economics@

Metal prices are at record highs in nominal terms though below previous peaks in real terms Nominal and real metal prices 300

Index: 2000 = 100

Nominal terms 250 Deflated by US CPI

200 150 100 50 0 56

2

61

66

71

76

Source: IMF International Financial Statistics; Economics@ANZ.

81

86

91

96

01

economics@

06

China is now the major influence on global demand for base metals and steel 1993-2002 World consum -ption growth†

3

2002-2005

Contribution to growth (%) of China

World consum -ption Other † EMs* growth

Contribution to growth (%) of China

Other EMs*

Aluminium

3.8

38

9

7.6

48

9

Copper

3.5

43

15

3.8

51

41

Lead

3.0

42

15

4.3

110

-7

Nickel

4.4

12

-11

3.6

87

-11

Steel

3.4

38

11

9.2

54

8

Tin

1.3

34

16

8.1

86

2

Zinc

3.4

42

10

3.8

113

7

† % pa * Emerging Markets (India, Russia, Brazil and Mexico) Source: IMF World Economic Outlook, September 2006 Table 5.3.

economics@

Base metal consumption in developing countries is likely to grow strongly over time Base metal consumption and GDP per capita, 2004 Tons

Base metal consumption per capita

80

Taiwan

70 60

Korea Germany

50

Italy

40

Japan

30 Thai- Malaysia China land Russia IndoSth Africa nesia India Brazil Mexico

20 10 0 0

4

Canada

5

Spain

Australia

US

France UK US$000

10 15 20 25 30 GDP (at purchasing power parities) per capita

Sources: ABARE Australian Commodities 2006; IMF World Economic Outlook September 2006; Economics@ANZ.

35

economics@

40

Per capita consumption of base metals and steel typically rises with income up to US$15 -20,000 US$15-20,000 Steel

Aluminium Kgs Korea

25

US

20 15 10 EU

China

5

Japan

US$000

Korea

900 800 700

Japan

600 500

US

400 300 200

China

100

EU

US$000

0

0 0

5

Kgs

1000

Steel consumption per capita

Aluminium consumption per capita

30

10 20 30 Real GDP (at PPP) per capita

40

Sources: IMF World Economic Outlook September 2006; (Figure 5.7); Economics@ANZ.

0

10 20 30 Real GDP (at PPP) per capita

economics@

40

Metal supply has responded more slowly to the acceleration in demand than in earlier cycles z Mining companies have to some extent been surprised at the strength of the upturn in demand – industry views on the outlook for prices were generally pessimistic in the aftermath of the Asian economic crisis

z The mining industry globally is more consolidated than in previous cycles – companies are more conscious of the impact that an increase in their own production may have on prices

z Mining companies now have alternative ways of spending windfall cash flows – expanding exploration or production is no longer the first instinct – takeovers, ‘special dividends’ and share buybacks are now much more common-place among mining companies 6

economics@

Strong demand combined with muted supply increases have driven metal stocks to low levels Aluminium 16 14 12 10 8 6 4 2 0

Nickel 20

Weeks' consumption

Weeks' consumption

15 10 5 0 65

75

85

95

05

85

95

Copper 14 12 10 8 6 4 2 0

7

Zinc 14 12 10 8 6 4 2 0

Weeks' consumption

65

75

85

05

95

05

Weeks' consumption

65

Sources: ABARE; AME Mineral Economics; Economics@ANZ.

75

85

95

economics@

05

Nickel and copper prices now very high relative to production costs – should prompt increased supply Ratio of price to cash operating cost of least efficient 10% of producers – selected base metals Nickel 3.0

Ratio

Aluminium

Copper 3.0

2.0

Ratio

Ratio

1.8 2.5

2.5

2.0

2.0

1.5

1.5

1.6 1.4 1.2 1.0 0.8

1.0

1.0

0.5

0.5

0.0

0.0 1985 1988 2002 2005 2006 trough peak trough up- curturn rent

8

0.6 0.4 0.2 0.0 1985 1988 2002 2005 2006 trough peak trough up- curturn rent

1985 1989 2002 2005 2006 trough peak trough up- curturn rent

Sources: Brooke Hunt Metal Consultants; International Monetary Fund World Economic Outlook September 2006 Table 5.5.

economics@

Modest increases in global production of most major mineral commodities now in prospect % change from previous year 19992004*

2005 (e)

2006 (f)

2007 (f)

Coal

5.0

7.4

2.2

2.2

Iron ore

5.9

10.3

11.7

9.2

Alumina

5.0

6.1

11.7

4.4

Aluminium

4.7

7.0

5.0

4.8

Copper

1.7

5.7

3.6

4.6

Lead

1.7

11.8

6.6

3.7

Nickel

3.3

5.8

4.7

3.0

Zinc

4.0

6.3

6.9

0.9

-0.6

0.0

0.0

4.0

Gold (mine) 9

* Average annual rate. Sources: ABARE, Australian Commodities September quarter 2006; Economics@ ANZ.

economics@

Prices of most energy and metals expected to ease from recent peaks – but only gradually Thermal coal US$/tonne

55 50 45 40

Gold

Aluminium 700 US$/oz

150 US¢/pound NY Merc futures

600

125 100

35 30 25

LME

75

20 01 02 03 04 05 06 07 08 09 10

400 300 200

50

01 02 03 04 05 06 07 08 09 10

01 02 03 04 05 06 07 08 09 10

Copper

Zinc

Nickel

400 US¢/pound

1400

350 300 250

1200

150

1000

125

200 150 100

LME

800

175 US¢/pound

LME

600

100

LME

75 50

200

01 02 03 04 05 06 07 08 09 10

10

US¢/pound

400

50

Comex

500

0102030405 0607080910

Note: Futures contract prices as at 12 October 2006. Source: Datastream; Bloomberg; Economics@ANZ.

25 01 02 03 04 05 06 07 08 09 10

economics@

Oil prices have been at elevated levels for some time now, and seem likely to remain so Nominal and real oil prices 100

US$ per barrel

90

Oil price in 2005 dollars

80 70 60

Futures prices as at 12 Oct 2006

50 40 30 20 10

Oil price in current dollars

0 70

75

80

85

90

95

00

Note: Oil price is West Texas Intermediate. Shaded periods indicate ‘oil shocks’. Source: Thomson Financial Datastream; Bloomberg; US Bureau of Labor Statistics; 11 Economics@ANZ.

05

economics@

10

High oil prices aren’t hurting growth as much as in the 70s/80s because it’s a different type of shock World oil supply and demand 90

Mn barrels of oil per day

85

Demand

80 75 Supply

70 65 60 55 50 45 70

12

73

76

79

82

85

88

91

94

97

00

03

Note: shaded areas denote ‘oil price shocks’. Sources: BP Statistical Review of World Energy 2006; ABARE Australian Commodities September Quarter 2006.

06

economics@

09

Developing countries now account for over threequarters of world crude oil demand Growth in world oil demand

Oil consumption 45

Millions of barrels per day

3.0

Developing or emerging economies

40

Millions of barrels per day Developing economies

2.5

Advanced economies

2.0

35

1.5

'Advanced' economies

30

1.0 25

0.5

20

0.0

15

-0.5 70

13

75

80

85

90

95

00

05

90

93

96

99

Note: ‘advanced economies’ are the US, Western Europe, Japan, Canada, Australia and New Zealand. Sources: BP Statistical Review of World Energy 2006; Economics@ANZ.

economics@

02

05

Developing country demand for oil is likely to grow rapidly as incomes rise Oil consumption and GDP per capita, 2005 Barrels

Oil consumption per capita

30

Canada

25 20

Korea

15

Mexico

10 5

Argentina Thailand Indonesia India

0 0

5

15

Australia Spain

Japan

Taiwan

Germany

France UK

Russia

Malaysia Sth Africa Brazil China 10

US

US$000

20

25

30

35

40

GDP (at purchasing power parities) per capita 14

Sources: The Economist ‘Survey of the World Economy’ 16 September 2006 p. 20; BP Statistical Review of World Energy 2005; IMF World Economic Outlook September 2006; Economics@ANZ.

economics@

45

China will become a major consumer of most forms of primary energy China’s share of global primary energy (%)

2003

2020 (f)

2030 (f)

28.1

40.8

44.0

Oil

7.0

11.2

12.7

Natural gas

1.3

3.4

3.8

Nuclear

1.7

5.5

9.2

Hydro & other renewables

8.9

13.4

12.2

Coal

15

Source: Energy Information Agency (2006).

economics@

Higher oil prices aren’t (thus far) leading to higher inflation and interest rates Oil prices and inflation 100 90 80 70

US$ per barrel (2005 prices)

% change from year earlier

Real oil prices

Oil prices and interest rates 16

100

14

90

12

60

50

8

50

6

40

30

4

20 10 0

G7 consumer prices (right scale)

70 74 78 82 86 90 94 98 02 06 Note: Shaded areas denote “oil price shocks” 16 Sources: Datastream; OECD; Economics@ANZ.

12

70

10

Real oil prices

`

0

0

6 4

20 10

10 8

30

2

16 14

80

60

40

% per annum

US$ per barrel (2005 prices)

G7 3-mth interest rates (right scale)

70 74 78 82 86 90 94 98 02 06

economics@

2 0

China’s resource needs and Australia’s resource endowments are remarkably complementary Australia’s share of world exports (%, 2004)

China’s share of world imports (%, 2004)

Metallurgical coal

53.6

3.5

Steaming coal

19.7

3.0

Iron ore

36.0

31.6

8.5

5.6

Nickel*

14.1

9.8

Zinc†

27.3

7.5

Lead†

32.9

17.8

30.3

na

Aluminium

Uranium 17

*

* Production and consumption, respectively. † Ores & concentrates. Sources: ABARE, Australian Commodity Statistics 2005 and Australian Commodities September 2006.

economics@

Resources trade has propelled China to Australia’s #2 trading partner Australia’s merchandise trade with China 14 12 10

% (12-month moving average)

Imports from China as a % of total Australian imports (ranked #2 in 2006)

8

Australia’s merchandise trade balance with China 0

A$bn (12-month moving total)

-1 -2 -3 -4

6 4 2

-5

Exports to China as a % of total Australian exports (ranked #2 in 2006)

0

-7 -8

92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

18

-6

Sources: Australian Bureau of Statistics; Department of Foreign Affairs and Trade.

92 93 94 95 96 97 98 99 00 01 02 03 04 05 06

economics@

China’s rapid growth and industrialization is a particularly & uniquely ‘Good Thing’ for Australia Ratio of Australian export prices to import prices

Long-term price changes for Australian exports and imports 8

170

% per annum (real US$ terms)

160 6

150 140

4

130 2

2004-05 = 100 Korean War wool boom Mid-1970s commodities boom

120

Keating's 'Banana Republic'

110

0

100 -2 -4 -6

90 80

Export prices

70

Import prices

1960s

19

China boom

1970s

1980s

60 1990s

2000s

50 55 60 65 70 75 80 85 90 95 00 05

Note: the ‘terms of trade’ is the ratio of export to import prices; it is a measure of the international ‘purchasing power’ of Australia’s exports. Sources: ABS; US BEA; Economics@ANZ.

economics@

‘Terms of trade’ gains since 1999 have been worth $2,844 pa to each Australian, on average Real gross domestic product and income per capita

Real gross domestic product and income 7

% change from year earlier (trend)

6

47

Real gross domestic income (GDI)

5

A$ 000 (at annual rates; trend; 2004-05 prices)

46 GDI per capita

45 44

4

43

3

42

1

GDP per capita

41

Real gross domestic product (GDP)

2

$1,062

40 39

0

-$1,783

38

00

01

02

03

04

05

06

00

01

02

03

04

05

06

Note: Gross domestic income (GDI) is GDP adjusted for changes in the terms of trade (ratio of export to import prices). Sources: ABS; Economics@ANZ. 20

economics@

Higher commodity prices have prompted a surge in resources -related investment … resources-related Export-oriented infrastructure investment

Capital expenditure by the mining industry 20 18

A$ bn (constant prices, annualized rate)

6.0

A$ bn (current prices, annualized rate) Electricity

5.0

16 14

4.0

12 10

Railways

3.0

8 2.0

6 4

1.0

2

Harbours 0.0

0 00

21

01

02

03

04

Sources: ABS; Economics@ANZ.

05

06

00

01

02

03

04

05

economics@

06

Coal, iron ore, LNG and alumina export volumes have been rising – but oil exports have fallen Volume of exports of mineral and energy commodities 260 250 240 230 220 210 200 190 180

17

Mt

14

15

12

14

10

13

8

12

6

02

Iron ore Mt

240 230

250

220

225

210

200

200

175

190

150

180

22

03

04

05

06

Mt

02

07

Nickel

275

02 03 04 05 06 07

16

Mt

16

02 03 04 05 06 07

300

LNG

Alumina

Coal

Kt

03

04

05

06

07

Crude oil 26

ML

21 16 11

02 03 04 05 06 07

Source: ABARE, Australian Commodities, September 2006.

6 02

03

04

05

06

economics@

07

The ‘resources boom’ has arrived at a time when the economy is bumping into capacity constraints Unemployment rate 7.5

CBD office vacancy rates

% of the labour force

7.0

Trend

6.5

Lowest in 30 years

6.0 Actual

5.5 5.0 4.5 00

01

02

03

04

05

06

12 11 10 9 8 7 6 5 4

%

Rest of Australia 00

%

84 Businesses reporting labour shortages as a constraint on output

20 15 10

03

04

05

06

Trend

82 81

Highest in history of survey (since 1989)

0

80 Actual (seas. adj. by ANZ)

79 78

00 23

02

%

83

`

5

01

Capacity utilization

Labour shortages 25

Sydney

01

02

03

04

05

06

Sources: ABS; National Australia Bank; Property Council of Australia.

00

01

02

03

04

05

economics@

06

So, increasingly, strong demand is not being met by increased domestic production Real domestic spending and output 8 7

How final demand has been met 6

Real % change from year earlier

Domestic final demand

6 5

5 4 3

4 3

2

2

1

Domestic production (GDP)

1 0

0

-1

-1 2002-03

-2 00

24

% point contribution to change in final demand

01

02

03

04

05

06

2003-04

Domestic production

2004-05 Stocks

2005-06 Imports

Note: ‘Final demand’ is the sum of domestic final demand (consumption and fixed investment) and exports. It is met by a combination of increased domestic production (GDP), running down stocks and imports. Source: Australian Bureau of Statistics; Economics@ANZ.

economics@

The economy is near the point in the cycle where the seeds of previous recessions have been sown In some important respects the Australian economy is at a similar stage to where it was in 1960, 1973, 1981 and 1989 – just before each of the past 4 recessions Three policy mistakes have traditionally been made at this stage of the business cycle z Allowing wages to grow faster than justified by

productivity in a tight labour market

– much less of a risk now that centralized wage fixation

is (almost) dead

z Failing to allow the Reserve Bank to raise interest

rates before inflation has begun to accelerate

– not a serious risk now that the RBA is ‘independent’

z ‘Giving away too much’ of the revenue dividend in

spending increases and tax cuts

– still a significant risk (as demonstrated in recent years) 25

economics@

Each year, the Government collects tens of billions of dollars more than originally forecast Successive Budget estimates of total tax revenues 260

$bn

$6bn

250

$18bn

240

$26bn

230

$22bn

220 210

$13bn

200 190 180 2004-05

2005-06

2002-03 Budget 2005-06 Budget 26

2006-07 Financial years 2003-04 Budget 2006-07 Budget

Sources: Budget Papers 2002-03 through 2006-07.

2007-08

2008-09

2004-05 Budget

economics@

Much of these windfall revenue gains have come from company tax Successive Budget estimates of company tax revenues 60

$8bn

$13bn

$bn

$19bn

55

$16bn

50 45

$8bn 40 35 30 2004-05

2005-06

2006-07

2007-08

2008-09

Financial years 2002-03 Budget 2005-06 Budget 27

2003-04 Budget 2006-07 Budget

Sources: Budget Papers 2002-03 through 2006-07.

2004-05 Budget

economics@

The Government has had a $263bn windfall over the past 4 Budgets – and ‘spent’ $248bn of it Net ‘bottom line’ impact of ‘parameter variations’ vs ‘policy decision’ (tax cuts or spending increases) 50

$bn

45 40 35 30 25 20 15 10 5 0 2003-04

2004-05

Cumulative impact of: 28

2005-06 2006-07 Financial years

2007-08

'Parameter variations'

Sources: Budget Papers 2002-03 through 2006-07 and Economics@ANZ calculations.

2008-09

2009-10

'Policy decisions'

economics@

The government is saving almost none of the windfall gains produced by the resources boom Commonwealth ‘underlying’ cash balance 20

Forecast surpluses smaller as a % of GDP than at previous cyclical and commodity price peaks

$bn

15

% 4 3 2

10

1

5

0

0

-1

-5 -10

$ bn (left scale)

As a % of GDP (right scale)

-15

-2 -3 -4 -5

-20 70 29

75

80

85

90

95

Sources: 2006-07 Budget Paper No. 1, Statement 13, Table 1 (and previous issues).

00

05

economics@

10

It’s likely that there will be at least one more rate increase before the middle of next year Interest rates 6.5

% pa

90-day bill yield

6.0

5.5 Cash rate

5.0

4.5

4.0 01

02

03

04

05

06

Shaded areas denote forecasts. 30 Sources: ABS; RBA; Economics@ANZ.

07

z In its most recent Statement on Monetary Policy, the Reserve Bank raised its forecast for ‘underlying’ inflation to 3% - the top of its ‘target range’ z It also raised its forecast for economic growth to 3½% - at the top of the range of estimates of Australia’s ‘potential’ growth rate, at a time when idle resources are becoming increasingly scarce z With another pre-election Budget likely next May, the clash between monetary and fiscal policy will continue … z … creating a situation where further increase(s) in interest rates are likely

economics@

The resources boom is keeping the A$ stronger than it otherwise would have been Economic influences on the value of the A$ Interest rate spreads 0.80

US¢

0.75

Basis points

A$-US$ (left scale)

Commodity prices 500 400

0.85

US¢

0.80

300

A$-US$ (left scale)

180

0.70

160

0.65 200 0.60

AustraliaUS 90-day interest rate spread, forward 1 year (right scale)

0.55 0.50 0.45

100

-100 01

02

03

04

05

0.65 140

0.60 RBA commodity price index (in US$) (right scale)

0.55 0

06

31 Sources: Datastream; Reserve Bank of Australia.

220 200

0.75

0.70

2002-03 = 100

0.50 0.45

120 100 80

01

02

03

04

05

economics@

06

Commodity prices and interest rate differentials have been working in opposite directions on the A$ Alternative hypothetical scenarios for the A$ If commodity prices hadn’t risen since June 2001 0.90

If the interest rate spread on the A$ hadn’t narrowed since July 2004

US¢

0.90 A$ as predicted by ANZ model

0.85

0.85

0.80

0.80

0.75

0.75

0.70

Actual

0.65

0.60

0.60 A$ predicted by model if commmodity prices had remained at June 2001 level

0.50 0.45 01

02

03

04

05

06

32 Sources: Datastream; Reserve Bank of Australia; Economics@ANZ.

A$ predicted by model if Australia-US interest rate spread had remained at July 2004 level

Actual

0.70

0.65

0.55

US¢

A$ as predicted by ANZ model

0.55 0.50 0.45 01

02

03

04

05

economics@

06

These factors will continue to work against one another – but from opposite directions Economic influences on the value of the A$ Commodity prices

Interest rate spreads 0.80

Basis points

US¢

500 450

0.75

400 0.70

350 A$-US$ (left scale)

0.65 0.60 0.55 0.50

250

150 100

0 02

03

04

05

2002-03 = 100

06

07

08

Shaded areas denote forecasts. 33 Sources: Datastream; Reserve Bank of Australia.

220 200

0.75 A$-US$ (left scale)

0.70

180 160

0.65 140 RBA commodity price index (in US$) (right scale)

0.60 0.55

50

0.45 01

US¢

300

200 AustraliaUS 90-day interest rate spread (right scale)

0.80

120 100

0.50

80 01

02

03

04

05

06

07

economics@

08

Two unusually complementary economies – but both face medium -term risks medium-term z The economies of China and Australia are remarkably

complementary to one another

– China’s ‘peaceful rise’ is extending Australia’s record-

breaking run of continuous economic growth

– A bilateral free trade agreement would help to cement

this relationship

z China needs to ensure that it avoids ‘bubbles’

emerging in sectors of its economy

– an indirect risk of its FX policy (as it was for Japan in the

second half of the 1980s)

z Australia needs to ensure that it does not ‘blow’ this

new-found prosperity

– as it has nearly always done at the same stage of

previous commodity price cycles

34

economics@