Forecasts need to be revised only if they were markedly inaccurate in the first place. In light of Tuesday’s mid-year economic and fiscal outlook, which revealed a worrying deterioration in Australia’s public finances since the May budget, do we blame bad luck or something else?
With respect to the $5 billion revenue hit in the forward estimates for the next two years as a result of falling export volumes and worsening terms of trade, do not accept that it is because of exogenous shock: an event that cannot be explained or reasonably anticipated using normal economic analysis. China’s declining appetite for commodities, the main driver of commodity export volumes and prices, was eminently foreseeable and should have been factored in by forecasters. The question is how to prevent Treasury officials from continually overshooting when it comes to China?
Let’s begin with Treasury’s record. Since 2006, Treasury has overestimated commodity export volume growth to China every year except 2009-10. Assumptions about price per tonne, which determine our terms of trade, have also been consistently heroic. Take iron ore. The 2014-15 and 2015-16 budgets wrote figures of $US96 and $US48 a tonne respectively into their revenue models. Independent commodity experts working on the ground in China warned anyone who would listen that those numbers did not reflect reality. Even now, Treasury’s revised figure of about $US$38 a tonne in the year ahead seems too high.
Avoid the usual suspects
How can national forecasters improve? A good start would be to avoid the usual suspects, and instead seek counsel from those who have no financial interest in whether the Chinese economy accelerates or slows. In particular, they should treat with an enormous grain of salt any alleged consensus proffered by much of corporate Australia, which benefits far more from an overly optimistic reading of developments in the Chinese economy than a more moderate and realistic one.
Consider the favoured narrative by our miners and financial advisers, who benefit from any frenzied corporate activity and financial churn that rapid growth in Chinese fixed investment is far from over because of inevitable urbanisation. In February, and with iron ore spot prices still more than $US60 a tonne, Rio Tinto chief executive Sam Walsh derided those believing prices to be heading towards $US30 – including the on-the-ground analysts mentioned above – as living in “fantasy land”. In May 2014, Andrew Forrest angrily slapped down those who would “bet against China” as the only guarantee of a loss he had seen for a long time.
This sanguine view and the urbanisation narrative was generally endorsed by our national forecasters over the past decade to the present time. But a simple examination of the facts and evidence should have caused national forecasters to smell a rat years ago. From 1980 to 1995, genuine Chinese urbanisation increased more rapidly than it did from 1995 to 2014. In that first period, crude steel production in the country increased by about 5 per cent each year. Yet from 1998 to 2014, crude steel production growth rates soared to about 18% a year, and steel production almost tripped from 2008 to 2014.
Little historical correlation
The point is that Chinese demand for steel or other metals bears little historical correlation with rates of urbanisation. When the country’s export-dependent economy was hit by recessions in the large consumer economies in North America and Europe from the time of the financial crisis in 2008 onwards, Beijing demanded that the state-controlled banking sector pump the economy with credit and it responded. The result was the largest fixed-investment stimulus in economic history.
Whereas fixed investment contributed 20 per cent to 25 per cent of gross domestic product growth in the 1990s, it was behind 55 per cent of growth in 2007 and 90 per cent in 2009, falling to a still-high 50 per cent now. That the period from 2008 to 2014 marked the most rapid increase of corporate debt in any eight-year period in economic history to fund the supercharged fixed-investment model – an amount exceeding $US17 trillion ($23.5 trillion) and equivalent to 150 per cent of the entire American commercial banking sector – is proof enough that the good times for commodity prices could never last.
Having joined corporate Australia in drinking the Kool-Aid, the period from 2009 became the “new normal” as far as national forecasters were concerned. And like our miners, who still have to be dragged kicking and screaming in accepting that the half-decade boom from 2008 onwards was a one-off, models designed by Treasury officials continued to underestimate the price-dampening consequences of supply-side increases from new and existing commodity mines around the world, and the unsustainable drivers of Chinese demand. The inevitable results were unrealistic forecasts for commodity prices and export volumes time and again.
Much greater scepticism
Even now, Treasury officials must treat official forecasts of Chinese growth, and assurances from Chinese officials about their capacity to maintain rapid growth, with much greater scepticism. Those firms and individuals with their money and people on the ground in China privately mock official growth figures of about 7 per cent as being half that in reality. In doing their own empirical investigations, they know Communist Party officials have no choice but to continue with the confidence trick and charade to attract foreign capital and know-how into the still-developing economy.
Australian officials need not openly question official data and viewpoints of Chinese counterparts. But good economic forecasting depends on close empirical investigation and understanding of China’s political-economy. They should include a buffer for a credibility gap when offering forecasts to allow for the discrepancy between Chinese propaganda and reality.
Errors made by national forecasters in terms of persistently over-optimistic assessments about the Chinese political-economy eventually embarrassed the Kevin Rudd, Julia Gillard and Tony Abbott governments when it came to fiscal credibility. With few excuses left, the same need not happen to the Malcolm Turnbull government.