Glenn Stevens: The resources boom
Remarks by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, at the Victoria
University public conference on The Resources Boom: Understanding National and Regional
Implications, Melbourne, 23 February 2011.
* * *
The rise in prices for natural resources and the associated planned increase in Australian
based capacity to supply key commodities is one of the largest such economic events in our
history. The Reserve Bank has had a good deal to say about it. I will touch again today on
the main points we have made.
I will not say much that is new. Nor will I be seeking to convey any messages about
monetary policy. Those matters were covered in some depth with the House Economics
Committee less than two weeks ago.
I will structure my remarks around four questions.

What do we know from previous booms?

What do we know about this one?

What don't we know?

Finally, how should that knowledge, and the limits to it, guide our response to the
boom?
What do we know about previous booms?
I am going to re-use a chart that originated in a research paper by Jonathan Kearns and
Christian Gillitzer1, with some updating. This was the basis of a previous address last
November2. I have noticed it being shown rather more widely of late, no doubt because of
the striking messages it conveys.
One thing we know, by observing this time series, is that large swings in prices for
agricultural and resource commodities, resulting in big variations in Australia's terms of trade,
have been a recurring feature of our economic experience ever since Australia became a
significant producer of such commodities.
There have been a number of big booms. They all ended. The really high peaks were quite
temporary - just one or two observations in this annual time series, such as in the mid 1920s
or the early 1950s. Periods of pretty high terms of trade lasted for some years in several
instances - as shown by the five-year average - but so far they have all been followed by a
return to trend, or even a fall well below trend.
Graph 1
We also know that these swings were very important for the macroeconomy. My colleague
Ric Battellino gave a very thoroughly researched speech on this question a year ago today.3
He looked at five major episodes, including the current one, over two centuries. Let me offer
a reprise of his four main observations.
First, global developments have always played a part in causing the booms. Changes to the
availability of capital or the emergence of large, low-income countries with rapid growth
prospects (Japan or China) have often affected the price of minerals and energy.
Second, these booms were always expansionary for the Australian economy overall.
Third and related, previous booms were usually associated with a rise in inflation. The
exception was the one in the 1890s, which occurred when the economy was experiencing
large-scale over capacity.
Fourth, the role of the exchange rate is crucial. The current episode stands apart from the
previous ones because all those booms were experienced with a fixed or heavily managed
exchange rate. This severely compromised the conduct of monetary policy, and also
muddied many of the price signals that the economy needed to receive.
In short, these episodes were major externally generated shocks that proved very disruptive,
not least because the country's macroeconomic policy framework was not well equipped to
handle them. The high levels the terms of trade reached on some occasions were not
permanent, but they did persist long enough to have a big impact on economic outcomes.
What do we know about this boom?
The main thing we know about the current episode is that it looks very large. It is being
driven by a big increase in demand for key Australian export commodities. Global
consumption of coal has increased by about 50 per cent over the past decade; consumption
of iron ore has increased by 80 per cent since 2003. Back then, Australia shipped around
half a million tonnes of iron ore each day; now it is over a million tonnes a day. Coal
shipments have been running at a rate of around 300 million tonnes a year, at least until the
recent floods. Australian capacity to export LNG is now around 20 million tonnes a year, up
from around half that in 2004. This looks like it will increase to over 50 million tonnes within
five years.
The rise in demand has been driven in large part by the rapid growth of key emerging market
economies such as China and India. Over the past decade:

the average annual growth of GDP per capita has been around 51⁄2 per cent in India
and almost 10 per cent in China;

the number of people living in cities in those two countries, especially China, has
risen by over 250 million, which implies having to expand or create cities (with the
attendant buildings and infrastructure) to house the entire population of Australia
more than 10 times over or, alternatively, to house the populations of France,
Germany and Japan combined; and

steel production has doubled in India and it has more than quintupled in China.
Thus far, the demand for resources has stretched the global capacity of suppliers. Prices of
key raw materials have consequently been driven upwards. As a result Australia's terms of
trade have risen sharply, to be about 65 per cent above the 20th century average level, and
about 85 per cent above the level that would be expected had the downward trend observed
over the 20th century continued. Even assuming the terms of trade soon peak and decline
somewhat, they are nonetheless, over a five-year period, at their highest since at least
Federation - by a good margin. With the terms of trade at their current level, Australia's
nominal GDP is about 13 per cent higher, all other things equal, than it would have been had
the terms of trade been at their 100-year average level. Of course Australia has substantial
foreign ownership in the resources sector so a good proportion of this income accrues to
foreign investors. Nonetheless, probably about half of that additional 13 per cent of GDP
accrues to Australians one way or another.
We also know that a large expansion in the resource sector's capacity to supply commodities
is being planned. Already, mining sector capital investment has risen from an average of
around 2 per cent of GDP over the past 25 years to about 4 per cent, which exceeds the
peak reached in the booms of the late 1960s and early 1980s. Given the scale of possible
additional investment projects that have been mooted, resources sector investment could
rise by a further 1-2 per cent of GDP over the next couple of years. If it occurs, this will be by
far the largest such expenditure of a capital nature in the resources sector in Australia's
modern history. Again, a significant proportion of the physical investment will be imported,
but a large domestic spend is nonetheless likely.
A further thing we know about the boom is that it is associated with a much higher level of
the exchange rate than we have been accustomed to seeing for most of the time the
currency has been market determined, a period of more than 25 years (though, over the long
sweep of history, the nominal exchange rate was often considerably higher than it is now).
On a trade-weighted basis, it is 25 per cent above its post-float average. The striking
relationship between the effective exchange rate adjusted for price level differentials (the
"real" exchange rate) and the terms of trade that is observable over quite a long period in the
data still seems broadly to be in place.
Interest rates also have a bearing on the exchange rate. Even though most market interest
rates are very close to medium-term averages, or even below them in some cases (e.g. the
cash rate and the 90-day bill rate), interest differentials have recently strongly favoured the
Australian dollar because of the persistence of extremely low rates in all of the world's major
financial centres. Moreover, the expectation that relatively high returns will be earned on real
capital in Australia - in mining for example - is a powerful factor influencing capital flows.
We know that changes in the real exchange rate are part of the textbook adjustment
mechanism to shocks like changes in the terms of trade. In past episodes, where movements
in the nominal exchange rate were more limited (or did not occur at all), a range of other
prices in the economy had to respond - arguably a more disruptive way of adjusting to the
shock. On this occasion, the nominal exchange rate has responded strongly. This helps to
offset the expansionary effect of the increase in investment, and also gives price signals to
the production sector for labour and capital to shift to the areas of higher return. In other
words, firms in the traded sector outside of resources are facing a period of adjustment. But
in the face of such a shock they were always going to face that adjustment, one way or
another.
What don't we know?
The main thing we don't know is how long the boom will last. This matters a great deal.
If the rise in income is only temporary, then we should not respond to it with a big rise in
national consumption. It would be better, in such a case, to allow the income gain to flow to
savings that would then be available to fund future consumption (including through periods of
temporarily weak terms of trade, which undoubtedly will occur in the future). Likewise it would
not make sense for there to be a big increase in investment in the sorts of resource
extraction activities that could be profitable only at temporarily very high prices. Moreover,
the economic restructuring that would reduce the size of other sectors that would be quite
viable at "normal" relative prices and a "normal" exchange rate - assuming there is such a
thing - would be wasteful if significant costs are associated with that change only to find that
further large costs are incurred to change back after the resources boom ends.
If, on the other hand, the change is going to be quite long-lived, then national real income is
going to be permanently higher, and we can look forward to enjoying significantly higher
overall living standards into the distant future. In that world, a great deal of structural
economic adjustment is bound to occur. In fact it almost certainly could not really be stopped.
It would not be sensible to try to stop it.
We know that the peaks of previous terms of trade booms were relatively short-lived. In the
current episode, the very high level of the terms of trade already seems to be persisting for
longer than in previous episodes. Is this telling us that we should expect the boom to
disappear at any moment? Or is it telling us that this episode is different from the others?4
In favour of the latter view, if China and India maintain, on average, their recent rates of
"catch-up" to the productivity and living standards of the high-income countries, and if they
follow roughly the same pattern of steel intensity of production as seen in the past in other
economies, a strong pace of increase in demand for resources will likely persist for some
time yet. On the other hand, resources companies in Australia and beyond are rushing to
take advantage of the current increase in prices by bringing new capacity on line. Will this
increase in supply be just sufficient to match demand? Will it be too little? Or too much? An
additional complicating factor is that serious attempts at reducing CO2 emissions would
probably change the story at some point. The lessons of history, moreover - that booms
don't go on indefinitely - are also too great to ignore.
At this stage, the Reserve Bank staff are assuming that the terms of trade will fall in the latter
part of the forecast horizon. The associated assumptions about key resource prices are
toward the conservative end of current market forecasts, which typically assume a smaller
fall in prices. Even under the Bank's current assumptions, however, the terms of trade are
still very high, by historical standards, at the end of the forecast period.
But any forecast or assumption made in this area is subject to wide margins of uncertainty.
We know that something very big is happening and has been for a while. We simply do not
know whether it will continue like this, or not.
How to respond?
How, then, should we respond to our knowledge, and to the limits of our knowledge?
To recap, we know that:

Previous commodity price and/or mining investment booms were big events that had
major expansionary and inflationary effects.

Those booms all ended, generally with more or less a total reversal of the earlier
rise in the terms of trade, though this often took some time. On some occasions, this
brought on a significant economic downturn.

The current boom looks bigger than any other since Federation at least, in terms of
the rise in the terms of trade over a period of several years.

The previous episodes occurred without the benefit of a flexible exchange rate to
help manage the pressures. On this occasion that particular price is adjusting, which
should help to contain the pressures and help the economy to adjust more
efficiently.
We do not know what the terms of trade will do in future. It would be rather extreme to
assume that the rise of China and India is a short-run flash-in-the-pan phenomenon.
Likewise it would be imprudent not to allow for a fairly significant fall in prices, even if only to
still pretty attractive levels, over several years.5 But the truth is that we will learn only
gradually what the detailed shape of the new environment is.
How should we handle this uncertainty?
A few simple messages seem to me to be important.
First, we should not assume that the recent pace of national income growth is a good
estimate of the likely sustainable pace. We should allow a good deal of the income growth to
flow into saving in the near term. We can always consume some of that income later if
income stays high, but it is harder to cut back absorption that rises in anticipation of income
gains that do not materialise.
To date, that precautionary approach seems to be in place. Households are saving more
than for some years and the much-discussed "consumer caution" has been in evidence.
Firms are consolidating balance sheets. Governments have reiterated commitments to stated
medium-term fiscal goals.
Second, there is going to be a non-trivial degree of structural change in the economy as a
result of the large change in relative prices. This is already occurring, but if relative prices
stay anywhere near their current configuration surely there will be a good deal more such
change in the future. Because we can't confidently forecast where relative prices will settle,
we cannot know how much such change is "optimal". Therefore we can't be sure that some
of it will not need to be reversed at some point. But the optimal amount of change is unlikely
to be none at all. So we should not look to prevent change; we should look to make it cost as
little as possible. In general, that means preserving flexibility and supporting adaptation.
Third, productivity is going to come back into focus, especially in sectors that are exposed to
the rise in the exchange rate. Their prices will be squeezed, and their costs potentially
pushed up by the demand of the resources sector and related industries for labour. Surely
maintaining viability will involve achieving significantly bigger improvements to productivity
than we have observed in recent years.
Fourth, if we have to face structural adjustment, it is infinitely preferable to be doing it during
a period in which overall income is rising strongly. If nothing else, in such an environment the
gainers can compensate the losers more easily. Many other countries face major issues of
economic adjustment in an environment of overall weakness.
Conclusion
At the risk of sounding like a broken record, the rise in Australia's terms of trade over the
past five years is the biggest such event in a very long time. It reflects powerful forces at
work in the global economy to which our country is more favourably exposed than most. It
presents opportunities and challenges. With a large boost to income, we need to think about
the balance between saving and spending, because we do not know the permanent level of
the terms of trade. I argue for erring on the side of saving for the time being, and I think this
is by and large what is happening so far. With a large change in relative prices, we should
also expect to see a good deal of structural change in the economy. A careful response to
that prospect is also needed, and no doubt your conference will examine such issues over
the day ahead. I wish you well in your deliberations.