Crowding out is an interesting economic concept – Straight Talking

Welcome again to our regular Straight Talking column – written by senior financial planner at ipac WA, Bob Mill

Crowding out is an interesting economic concept. Usually it relates to the impact of government deficit spending on private investment. The idea is that additional demand by government for relatively scarce loan funds means fewer funds and higher interest rates for investors in the private sector.

But crowding out can also express itself in parts of an economy and, as we shall see, in an entire economy. A surge in demand for anything, at least in the short term, sees a spike in its price and a rationing of its use [ to only those willing to pay the higher price

West Australians are very familiar with the crowding out effect of the resources boom.  A direct effect was seen in the demand for office space in Perth’s CBD, as well as West Perth. At one stage Perth had the tightest commercial rental market of any CBD on the planet and West Perth did not have a single square metre of available office space

The indirect effects of the resources boom became obvious to employers of all description as they were forced to lift wages and salaries to keep staff, in the face of lucrative job opportunities in the state’s north west.

The GFC produced an extraordinary turn around, making a mockery of demand driven crowding out. The market price for things associated with resources fell quickly: in   West Perth and Perth’s CBD, former tenant beggars became choosers.

While many small-to medium sized businesses in the resource sector failed, the giants survived. Indeed, after some anxious months, the fortunes of the giants changed. First prices and profits surged and then roared, delivering staggering profits to the survivors. What happened?

In short, crowding out, generated by massive Chinese spending. The Chinese government, in response to the GFC, directed the spending …. and Australian businesses associated with the surviving resource giants could hardly believe their luck, as prices and profits rose to record levels. All of this when much of the rest of the economy was either in recession, or close to it. No wonder Australia was deemed to be a ‘two speed economy’.

Things change, however, and soaring resource and energy prices induced a massive increase in supply. Unsurprisingly, prices and profits sagged significantly. The share prices for these companies overshot both on the way up and on the way down.

The Australian economy, however, did not slide into recession. Plunging resource and energy prices produced a lower Australian dollar and our export sector boomed, especially education and tourism. A resurgent building sector also helped.

Lo and behold, led by another bout of Chinese spending, commodity and energy prices are on the move again, giving rise to optimism in some quarters and predictable doubts in other quarters. For the latter, it’s along the lines of ‘Don’t you realise that China’s economy is really a sand castle, about to collapse under the weight of property debt?’

Not so fast doubters. Do you really think that the people running the place are going to badly flunk its rebalancing, from a manufacturing-led economy to one based on services and household consumption?  China has two distinct things going for it in its rebalancing act. First, it is a one-party state which can mobilise resources in the manner of a command economy. Second, in the event the economy stumbles along the way, it has a massive pool of earned funds at its disposal. It does not have to resort to ordering its central bank to print money.

The Chinese economy grew by 6.7 per cent in the first half of 2016. A halving of that rate would have an adverse effect on Australia and the rest of the world. But such a result would cause acute embarrassment to the   ruling Chinese Communist Party. You get the feeling that President Xi and co would take strenuous steps to avoid embarrassment.

All in all, it is likely that China will rebalance its economy without suffering   a significant reduction in its rate of economic growth. Australian business firms associated with commodities and energy are likely to continue to feel strong demand from China. Let’s not forget that Chinese households will require resources and energy…….and that companies providing services will require resources   and energy for the buildings they occupy, the vehicles they use on the roads and the additional infrastructure that will need to be provided.

While the Chinese leaders may be ruthless, it’s unlikely they are stupid. Furthermore, they have the means to rebalance their economy,

In an economic world where the US is going pretty well, Europe improving and Japan hanging on, it’s hard to buy the economic line that things look bad. For Australia, this is good news.  Even better Australia is likely to continue to experience China’s gift: crowding out.

If you would like to discuss anything that you read here, feel free to contact an ipac WA financial planner today to meet with us in our Perth offices and see how change can impact you.

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