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Australia: Imminent Recession?

The decline in Australia's terms of trade...

AS AUSTRALIAN data releases go, the 'National Income Accounts', which measure the country's economic growth rate (GDP), are probably the biggest lagging indicator you could ask for, writes Greg Canavan for the Daily Reckoning Australia.

Data released by the Australian Bureau of Statistics (ABS) yesterday tells us what was happening in the Australian economy over two months ago. Not very useful, you may think.

That's true as far as financial markets are concerned. By the time the data comes out, the market pretty much knows the details. Two months is a long time to wait, and the economic growth numbers are basically a compilation of other data points released earlier in the period.

Perhaps the ABS should send a delegation of its bean counters over to China for an advanced course in statistical compilation. The Chinese manage to report GDP data in a matter of weeks. Although it is easier when you already have the growth figure you want to report...just work backwards and make the numbers fit.

Although the Aussie numbers are old news by the time we see them, it is worth having a look in detail, because it gives important clues as to where the Australian economy is heading.

The conventional view is that we in Australia managed to avoid the carnage playing out in the rest of the world in recent years because of better economic management, better regulation in the banking sector, and our proximity to China.

As we point out in our forthcoming report, that view is wrong. Yesterday's economic growth/decay figures serve as a good talking point for this new report, because they contain the evidence that we've been discussing for ages.

What do we mean by that?

Well, for many years the media simply reported the 'headline' economic growth rate. Over the past 12 months, the headline rate of economic growth in Australia was 3.1%. That's pretty good. It was 0.5% (2% annualised) during the September quarter. So we're slowing down, but nothing to panic about, right?

Not really. Australia's intimate economic relationship with China, in combination with a financial system prone to credit bubbles and widely fluctuating commodity prices, has changed the way the media reports on economic growth.

The standard GDP figure you generally see reported (the 3.1% annual growth one) is a 'chain volume measure' of growth. It tells you how much the economy produced, but it removes the effects of prices changes from the equation. So it's not really a measure of actual economic well-being. It just reflects an economy's production.

Ever since China engineered a credit boon to escape the global financial crisis in late 2008, which had an explosive effect on Australia's bulk commodities like iron ore and coal, the 'terms of trade' became a common talking point in the media. The terms of trade are important because when you adjust headline GDP for changes in the term of trade you get a much closer approximation to the growth or otherwise of the economy that we all live and work in.

The terms of trade measure how much income we receive for our exports relative to the income we pay out for imports. Rising prices for commodities, which we export, and (mostly) falling imports prices translated into a rising terms of trade and an increase in national incomes.

The measure that reflects the impact of the terms of trade is 'Real Gross Domestic Income' (Real GDI). During the June quarter in 2010, when the benefits of China's credit bubble started flowing into Australia via its bulk commodity exports, real GDI increased 4%...that's 16% annualized! As the ABS said at the time, it was the largest growth in real GDI since March 1973.

Around this time the governor of the RBA, Glenn Stevens, started talking in detail about the terms of trade. It was why he kept on increasing interest rates during 2010...

And it's why he's cutting interest rates to historically low levels now. Australia's terms of trade is declining. It fell 4% in the September quarter, leading to a real GDI decrease of 0.4%. And instead of reporting on the 3.1% annual increase in GDP, today's Australian Financial Review went with the headline 'National Income Slumps'.

Over the past year, real GDI is down 0.2%. That's recession territory. It explains why many people 'feel' like we're in a recession even though the headline numbers look good.

It's also indicative of why things could get much worse in 2013. We spell it all out in our report, but the point is, getting a pay cut (which is what a fall in national income represents) when you have lots of debt (Aussie mortgage debt as a percentage of GDP is still amongst the highest in the world)'s not good.

Because of this high debt, credit growth is running at very low levels, despite recent interest rate cuts. That is, no one wants to take on more debt. And because of the large amount of the nations' savings locked up in term deposits, you have to wonder about the effects of more interest rate cuts. Yes it might help 'hard-working Australians' reduce their mortgage by $50 a month, but it also cuts into the income of retirees. Net net, the benefit is marginal in the short term and negative in the long term.

Lastly, we might not be able to afford the luxury of super low interest rates. Earlier this week the ABS reported Australia's current account deficit was nearly $15 billion for the September quarter. That means the capital account was in surplus by the same amount (these things have to balance). In other words, we borrowed $15 billion in three months to maintain our standard of living. Over the past 12 months, we've run up a tab of $52 billion.

Despite the China boom, we can't even manage to generate a lasting trade surplus. No one seems to worry about this situation because it's existed for so long. We've relied on the kindness of strangers (who kindly send us their surplus production...their savings) for so long we think it's a national right.

We have no idea how long this will last, but we know it can't last forever. Many of the reasons foreigners felt good about sending their savings here (China growth, high interest rates, low government debt) are changing or will soon change. If foreign capital leaves in a hurry, we'll have one almighty recession in Australia. We think it's time to prepare now.

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Greg Canavan is editorial director of Fat Tail Investment Research and has been a regular guest on CNBC, ABC and BoardRoomRadio, as well as a contributor to publications as diverse as and the Sydney Morning Herald.

See the full archive of Greg Canavan.

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