Australia finds itself in an enviable situation. While many of the world’s economically developed nations are slowing down, Australia is speeding so fast it’s going to have trouble stopping.

Over the past two years the growth in the Australian economy has been phenomenal, mostly due to skyrocketing commodities. Fully 17% of Australia’s economy depends upon exporting raw materials including coal, iron ore, gold, meat, wool, alumina and wheat. So when prices go up, Australia gets richer.

At first blink, it seems that the slowdown currently underway in the U.S., the UK and the Eurozone, whether technically a recession or not, would tend to choke off those exports. However, most of Australia’s shipments go to Asia, including Japan (19.4% in 2007), China (13.6%) and South Korea (7.8%), as compared to the U.S. (5.8%) and the UK (3.7%), and those to the Eurozone were so minor they were under the Australian Bureau of Statistics’ official radar. With economic growth in Asia remaining fairly strong in global terms, the market for Australia’s exports remains hungry.

Because of this economic surge, the Australian budget has run a surplus since 2002, although the government keeps several million dollars in bonds available as risk-free securities.

More Jobs than Workers

Australia also has an extraordinarily tight labor market. In May 2005, the unemployment rate was 5.1%. That’s not bad, but by May 2008 it had fallen to 4.3%, and many businesses reported that they’d love to expand but just couldn’t find the skilled workers to fill new positions.

In fact, the economy has been accelerating so fast it’s starting to overheat. Rising consumer and corporate demand has boosted imports even faster than exports, with passenger cars, computer and telecommunications equipment, pharmaceuticals and petroleum products being offloaded onto Australia’s docks daily. This demand-pull, coupled with the cost-push of higher fuel, energy and food prices, has sent inflation spiraling. On average, prices for finished goods were 1.3% higher in March 2008 than in December 2007 and 4.25% higher than March 2007.

In their fight to slow business and consumer demand and thereby curb inflation, the Reserve Bank of Australia has raised interbank lending rates twelve times since May 2002. In March 2008, the official rate hit 7.25%, in contrast to the U.S. at 2.00%, the Eurozone at 4.00%, Japan at 0.50% and Switzerland at 2.75%, which should speak volumes about the relative speeds of those economies.

Interest rates for retail clients, of course, are higher than interbank rates, and 12.0% per year for an Australian credit card or car loan is considered a pretty good deal right now. Variable rate home loans start at 7.98% and fixed rate at 9.53%—if you can find a lender willing to offer one.

Desired Results

Such a high price for credit has answered the RBA’s intent, and consumer and business demand has diminished. In April 2008 new loans for buying a home fell by 5.8% from March for a total decline of 17.3% over the previous three months, and in June consumer sentiment fell to its lowest level since December 1992.

But the prices of Australia’s export commodities just keep rising. Driven by strong demand for steel in developing Asian nations, prices for Australia’s iron ore rose by 85% in June 2008. Wheat has more than doubled over the last two years, and gold has averaged well above US$850 per ounce for the year to date.

To make matters worse, Australia’s high interest rates have made it a favorite target for the carry trade, an investment strategy where funds are borrowed in a nation with a low interest rate and invested in a nation with a high one. The investor earns the difference between the rates, currently 6.75% between Japan and Australia, but runs the risk that violent exchange rate fluctuations due to financial market fears will wipe out the profits. The weekly chart above of the Australian dollar versus the Japanese yen graphically illustrates that risk.

The big drop in the middle of the chart marks the beginning of the subprime mortgage crisis, but note that every time the bottom falls out of the carry trade market, it just comes right back up.

With economic activity plunging, the RBA is understandably hesitant to raise interest rates further and risk throwing a vibrant economy into recession. But if that brake doesn’t hold, the influx of exports and foreign investments will refuel demand-pull and cost-push, starting the inflation cycle all over again.

Related posts:

1. Decoupling Theory: How Well-Insulated Are Asia and Australia?
2. Where will the productivity growth come from?
3. Too Much of a Good Thing in Australia?
4. Very Soon, You Can Invest in Australia
5. What Is the Rate of Economic Growth Implied by Current Equity Prices?