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Analysis: Australia's success story takes a chilling turn

An office worker talks on his phone as he looks the stock board at the Australian Securities Exchange (ASX) building in central Sydney June
An office worker talks on his phone as he looks the stock board at the Australian Securities Exchange (ASX) building in central Sydney June

By Wayne Cole

SYDNEY (Reuters) - Australia faces a gathering threat to its 21-year run of recession-free growth that will likely require the central bank to cut interest rates to record lows and keep them there for some time, if the winning streak is to stretch to 22.

The slowdown in China has deflated prices for Australia's key resource exports while forcing miners to scale back on their most ambitious expansion plans. When the country reported its widest trade deficit in three years for August, it seemed just a taste of what was to come.

"It's like we're watching a slow motion train wreck," said Su-Lin Ong, a senior economist at RBC Capital Markets.

"The decline in export earnings will take toll on wealth, incomes and consumption right across the economy," she explained. "And it's happening when fiscal policy is being tightened and the Australian dollar is restrictively high."

As a result, she expected the economy's strength would bleed away into 2013, leaving it dangerously exposed should a seven-year old boom in mining investment also top out that year.

The government and central bank still forecast growth of around 3 percent for the next couple of years.

But when the mining splurge turns, as it must, there will likely be significant quarterly falls in investment even as the level of spending stays high.

And since investment is set to reach a heady 9 percent of Australia's A$1.5 trillion ($1.53 trillion) in annual gross domestic product (GDP), such falls could easily cause a couple of quarters of contraction, the textbook definition of recession.

PAST THE PEAK

The danger was hinted at by the Reserve Bank of Australia (RBA) last week when it surprised most economists by cutting interest rates a quarter point to 3.25 percent.

That was the lowest in three years and only a whisker from the nadir of 3 percent touched in the global financial crisis.

"The peak in resource investment is likely to occur next year, and may be at a lower level than earlier expected," wrote RBA Governor Glenn Stevens in explaining the latest easing. Previously the bank had thought spending would crest as late as 2014.

"As this peak approaches it will be important that the forecast strengthening in some other components of demand starts to occur," said Stevens.

The central bank has been hoping that as the investment stage of the mining boom topped out, other sectors such as home building, retailing and tourism would take up the slack.

So far, however, the transition has been glacial. Growth in mortgage credit, for instance, was the slowest on record in August, while sales of new homes hit a 15-year trough.

Consumer borrowing has been going backwards with Australians preferring to squirrel cash away in banks rather than risk investing in homes or shares. Since 2008, bank deposits have climbed by a cool A$260 billion, or almost 60 percent.

Household debt also remains high, at around 149 percent of disposable income.

Any foot dragging by the rest of the economy could have serious implications for unemployment as mining has been a big hirer in the last couple of years, helping keep the jobless rate down near 5 percent.

But while a lot of workers are needed to construct mines or liquefied natural gas projects, it takes far fewer to actually run them. This was a point highlighted recently by the head of the RBA's economics department, Christopher Kent.

He estimated that, for iron ore mines, four times more people were employed in the construction phase than needed to dig the steel-making mineral. For LNG projects, the difference was more like 15-20 to one.

"So while employment and wage growth in the resource sector is presently robust, it is possible that this may start to reverse in the next couple of years," Kent cautioned last month.

When cutting rates this week, it was notable that the RBA was already sounding more downbeat on the jobs front by saying the labor market had generally softened.

NOT PLAYING ITS PART

Policymakers have long assumed the Australian dollar would ease the transition by falling sharply and so make life easier for sectors such as manufacturing and tourism.

But for investors to dump the local dollar they have to buy some other currency, and attractive alternatives are few and far between these days.

Central banks in the United States, Japan, the UK and Switzerland are all adding to the supply of their currencies either through quantitative easing or outright intervention.

The European Central Bank has not gone quite as far as yet, but grinding recession and endless political risk are not exactly a recommendation for holding euros.

Australia's triple-A rated debt also remains a big draw for sovereign funds and long-term investors wary of the risk of downgrades elsewhere.

Thus while the Aussie dollar has eased in recent weeks, it remains high historically. Weighted against a basket of major currencies, its current level of 75.8 is not that far from 27-year peaks and a world away from the lows of 51.0 touched in the aftermath of the global financial crisis.

That puts the onus on the RBA to do more, particularly as Australia's Labor government is politically shackled to a painful fiscal tightening aimed at delivering a promised budget surplus years before most other developed nations.

Unlike past downturns, inflation is still low, giving the central bank more room to reduce borrowing costs.

"The end of the commodity price and associated capex boom means more will probably have to be done to stimulate domestic demand," said Adam Donaldson, head of debt research at Commonwealth Bank of Australia.

He thinks 10-year government bond yields could get down to all-time lows of 2.5 percent in coming months, from a current 2.93 percent, with the RBA's cash rate not too far behind.

"The strength in the Aussie against this backdrop is inherently disinflationary - so we look for interest rates to remain low for an extended period as the economy navigates this difficult path." (Editing by Kim Coghill)

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