Australia is a relatively open, trade-exposedeconomy. This means that changes in othercountries’ demand for our goods and servicescan have significant implications for our economy.For example, an increase in global demand forAustralia's exports, if not matched by an increasein supply, will result in an increase in the price ofthose exports.
The ratio of export prices to import prices is calledthe terms of trade. This Explainer outlines theeffects of the 2005–11 terms of trade boom on theAustralian economy.
What Caused the Terms of Trade Boom?
The terms of trade boom was driven by verylarge increases in the prices of some of Australia'scommodity exports. Australia has plentiful suppliesof natural resources, including the second largestaccessible reserves of iron ore in the world, the fifthlargest reserves of coal and significant gas resources.For a long time, commodities have made up asizeable share of our exports.
From the mid 2000s, the prices for commoditiesused to produce steel and generate energy –including iron ore, coal and natural gas – rosesharply. This was because global demand for thesecommodities increased significantly and supplywas unable to keep up. The increase in globaldemand owed to a large increase in demand forsteel and energy, driven by rapid urbanisationand industrialisation in China and some otheremerging economies. Urbanisation (the movementof people from rural areas to towns and cities) andindustrialisation (the development of manufacturingindustries) requires investment in new housing,factories and transport infrastructure – all of whichuse steel in their construction.
As a result, Australia's terms of trade reached veryhigh levels. In fact, in 2011, the terms of trade werearound 75 per cent above the average of thepreceding century. This was also a longer terms oftrade expansion than in previous episodes.
How Did the Terms of Trade Boom Affect the Australian Economy?
During the boom
Mining investment
These extraordinary commodity price increasestriggered a massive amount of investment inmines and mining infrastructure across Australia.As prices for commodities increased, mining firmswere keen to increase production to profit fromthe higher prices. To extract more commodities,mining firms expanded existing mines anddeveloped new mines, leading to the largestresources investment boom in Australian history.For the 50 years leading up to the terms of tradeboom, mining investment had averaged just over1½ per cent of GDP. In 2012, mining investmenthad increased five-fold from its level in 2004(from around $20 billion to $130 billion), peakingat 9 per cent of GDP.
Demand and profits
The increase in mining revenues andinvestment spilled over to other parts of theAustralian economy:
- Increased demand for workers and higherwages: Higher demand for commodities andinvestment in new mines and infrastructure increased demand for workers in the miningsector, as well as other related sectors(including construction, engineering,finance and insurance, legal and transport).This resulted in an increase in both thenumber of workers employed and thewages these workers were paid, which inturn supported household incomes andconsumption. In other words, more Australianshad more money to spend on goodsand services.
- Government revenue: Increases in thequantities of commodities extracted andhigher prices resulted in higher profits formining companies, which led to increasedtax and royalty receipts by federal, state andterritory governments.
- Increased shareholder profits: Increasedafter-tax profits in the mining sector and otherrelated industries flowed through to companyshareholders, a proportion of which wereAustralian residents.
The large-scale investment in the mining sector,alongside higher incomes, increased overalldemand in the Australian economy. This, in turn,led to increased labour demand, which putdownward pressure on the unemployment rateand upward pressure on wages, resulting in higherinflationary pressures.
Offsetting effects from the exchange rateand the cash rate target
The increase in the terms of trade led to anappreciation of the Australian dollar. At the sametime, the Reserve Bank Board increased thetarget for the cash rate in response to higherdemand and inflationary pressures. The effectsof the increase in the cash rate target and appreciationof the Australian dollar were more obvious inthe non-mining sectors of the economy, suchas the tourism industry, which were not directlybenefiting from higher commodity prices. To learnmore about the effects of changes in the cash rate targeton the domestic economy, see Explainer: TheTransmission of Monetary Policy.
Regional differences
The effects of the increase in mining investmentwere felt differently across various parts of thecountry, and were more easily identifiable in theresource-rich states of Western Australiaand Queensland.
Commodities are spread unevenly across thecountry, with Western Australia and Queenslandhaving the highest concentration of knownreserves. Almost all iron ore mining occurs inWestern Australia (mostly in the Pilbara region inthe north-west of the state). Two-thirds of coalmining is in Queensland. In the case of natural gas,the bulk of production is from Western Australiaand Queensland.
After the boom
Eventually, the new investment in mines andmining infrastructure meant that Australia wasable to export more iron ore, coal and gas(shifting the commodities supply curve out fromS1 to S2,in response to the initial upward shift indemand from D1 to D2).At the same time as thisadditional supply became available, demand forcommodities from China and other parts of Asiaslowed (demand shifted back in from D2to D3).The combined effect of this increase in supply andfall in demand was a decline in commodity pricesand Australia's terms of trade (with prices fallingfrom P2 to P3 andquantities increasing fromQ2 to Q3).
This decline in the terms of trade had the oppositeeffect on the economy of the increase in the termsof trade. Falling commodity prices weighed ongrowth in GDP, employment, profits, wages andfiscal revenues, as well as on inflation. In response,the Reserve Bank Board cut the cash rate target.
The effects of the falls in commodity demandand prices were felt most in the mining sectorand the key mining states of Western Australiaand Queensland, but were also evident acrossthe country.
In the non-mining sector, growth in activityand employment picked up following the endof the boom. The reduction in the cash rate targetbetween 2011 and 2016 assisted in rebalancingactivity towards the non-mining economy. Thedepreciation of the Australian dollar between2013 and 2015 also supported activity in the nonminingtradable sector, which includes agriculture,manufacturing and some services. Indeed, serviceexports have made a noticeable contributionto GDP growth over the past few years, withtourism, education and business services exportsall increasing.
Compared with other terms of trade cycles
Compared with previous terms of trade cycles, the2005–11 episode was much less disruptive to thenational economy. Terms of trade surges in the1950s and the 1970s produced significant inflationon the way up and were followed by majorslowdowns or recessions in economic activity asthe terms of trade fell back. In contrast, duringthe 2005–11 boom, inflationary pressures wererelatively contained as the terms of trade rose. Andon the way down – even as commodity prices fellsharply and mining investment declined – growthin GDP, employment and wages was only a littleweaker than average.
One reason for the relatively smooth transition afterthe 2005–11 boom was the floating exchange rate(the Australian dollar was floated in 1983). At itspeak in mid 2011, one Australian dollar was wortharound US$1.10. By 2017, the Australian dollar wasaround 30 per cent lower than that against theUS dollar, and about 16 per cent lower againstthe currencies of Australia's trading partners moregenerally. This movement – both up and down– was part of what helped insulate the economyfrom the effects of this particularly large terms oftrade cycle. For more information on the effectsof changes in the exchange rate on the domesticeconomy, see Explainer: Exchange Rates and theAustralian Economy.
The economy's relatively smooth adjustmentwas also helped by a more flexible labour marketthan in earlier terms of trade booms. In the past,Australia's centralised wage-setting system hadthe effect of spreading wage increases acrossthe economy to sectors where profitability hadnot increased, resulting in higher inflation andunemployment.
