Build a big electric fence to secure the nation

In preparing for the very real prospect of a fully-fledged Indo-Pacific War between China and the West, Australia faces an enormous paradox, writes Christopher Joye from Coolabah Capital: we are acquiring nuclear-powered submarines to defend ourselves against this threat and yet our entire nation is dependent on imported foreign fuel.
Christopher Joye

Coolabah Capital

In the AFR I write that in preparing for the very real prospect of a fully-fledged Indo-Pacific War between China and the West, Australia faces an enormous paradox: we are acquiring nuclear-powered submarines to defend ourselves against this threat and yet our entire nation, and almost all our civilian and defence transport infrastructure, is dependent on imported foreign fuel.

More than 80% of Australia’s oil comes from overseas, most of which is imported from Asia via, ironically, the contested South China Sea. This is further exacerbated by finite stockpiles of fuel, which would only last for a few weeks if we were ever denied access. 

According to the Liquid Fuel Security Review, Australia has just 18 days’ worth of petrol and 22 days of diesel supply, although the government is working hard to extend this.

The Russia-Ukraine conflict has cast into relief the enormous dependence of Europe (and many other countries) on Russian oil, gas and coal, which have emerged as a crucial source of leverage for Putin’s kleptocracy.

The war itself has underscored the importance of external oil supplies, which have been repeatedly targeted by both sides, and the capacity of a nation to continue to provide troops with weapons and energy. The Ukrainians have, for example, had immense success isolating, ambushing, and destroying forward-deployed Russian armour that has found itself disconnected from fuel and other reserves.

Australia’s foreign energy vulnerabilities were underlined by China’s decision in 2021 to " ban the export of urea, which is required to produce the diesel exhaust fluid “AdBlue” that most modern cars, trucks, and other vehicles/equipment rely on. Since 80% of our urea came from China, the ban threatened to cripple Australian supply chains within weeks.

The national security solution is for the Federal government to invest in, and massively accelerate, the electrification of Australia’s civilian and military transport infrastructure. Put simply, we need to build a powerful “electric fence”.

In any Indo-Pacific war, we will not be able to import foreign commodities. We desperately need, therefore, energy autonomy. And one latent resource Australia possesses in abundance is obviously solar power. (Disclosure: our family uses two electric vehicles.)

A recent ABC analysis cited John Blackburn, a retired air vice marshal, and Michael Shoebridge, the director of defence, strategy and national security at the Australian Strategic Policy Institute.

Blackburn argues Australia’s economy would be shuttered within weeks if China, which is stealthily encircling our nation with a string of strategic military bases, ports and runways located in proximate nations, wanted to deny us access to seaborne imports.

"The problem is all the fuel and oil that comes to us on foreign-owned or foreign-controlled ships,” Blackburn says. “We don't have any Australian flagged ships that can move it. And we're not only dealing with foreign companies, we're dealing with foreign governments. So, we do not have good energy security as it relates to fuel and that's a problem."

Shoebridge says that we need to “turn our strategic location and vulnerability to extended supply chains to an advantage” by using renewable energy to enhance our resilience and security.

Both political parties have thus been presented with the perfect platform to fuse together otherwise disparate security and climate change imperatives.

The federal government should provide incentives to support the rapid conversion of all civilian and military transport from fossil fuels to domestically generated renewable electricity. 

We need to promote the use of electric vehicles and national charging infrastructure to effectively use them. And we should further subsidise research and development on, and commercial investments in, solar generation and storage at the household, corporate, and government levels.

Similar resource constraints—labour and supply shortages that are boosting wages and consumer price inflation—have convinced the Reserve Bank of Australia to commence the process of normalising its cash rate.

Financial market expectations for RBA hikes have dramatically increased the cost of fixed-rate loans, which is shifting almost all marginal demand into cheaper variable-rate products. This is a dramatic change from 12 months ago when the majority of mortgage flows were for fixed-rate loans.

In October last year, this column projected that national home values would correct about 15-25% after the first 100 basis points of RBA hikes. But we also asserted that prices would climb at least another 5 percentage points before that happened, lifting total capital gains since the end of the last major downturn in mid-2019 to a staggering 36%. (As it happens, national home values have indeed risen by 5% since October.)

The correction we expect, which almost all bank forecasters have come to embrace, will be an orderly and mechanical payback for the fact that the RBA’s reduction of its cash rate from 1.5 per cent in May 2019 to 0.1 per cent in November 2020 massively boosted household purchasing power.

Normalising its cash rate to 1.5% will unwind some of these purchasing power improvements, although this should be mitigated by robust wages growth, which is why we believe residential real estate will retain more than half the capital growth it has realised since mid-2019.

Relentless talk of rate hikes coupled with a huge increase in the cost of fixed-rate loans has already had a striking impact on the vanguard housing markets of Sydney and Melbourne, where prices have flat-lined since the end of November 2021 (after extraordinary appreciation).

The boom nonetheless persists across much of the rest of the nation, led by the comparatively cheap Queensland market. Nationally, home values continued to rise in the month of March, albeit at a modest 0.3% pace.

As CBA’s Gareth Aird has noted, this hiking cycle will, however, be different to those in the past because of the much greater household sensitivity to interest rate changes, and the fact that up to $500 billion worth of super cheap fixed-rate loans written carrying interest rates in the low 2% territory will roll-off over the next two years into variable-rate products that slug borrowers with a circa 75-125 basis point rate increase.

As house prices gradually correct, and the RBA observes its transmission mechanism working in practice, it is likely to pause once the cash rate hits 125-150 basis points. The is certainly no precedent for the RBA hiking rates through a 10 percent plus decline in the value of Australian households’ most important asset.

Much higher interest rates and resource constraints are also sensibly forcing governments to revisit the practical roll-out of their infrastructure investment plans. 

The SMH reported on Thursday that the NSW government’s prudent plans to delay major infrastructure projects will extend to education and health. NSW has flagged that it may have to defer several mega-projects, including the Beaches Link motorway and an extension of the Parramatta light rail line, due to labour and material shortages.

Premier Dominic Perrottet said he was evaluating “all our projects, whether that’s in transport, roads, health, education”. “We need to reassess timelines of our infrastructure delivery,” Perrottet continued. “It is a balance of ensuring that we continue to drive infrastructure investment but at the same time we have the labour and budget capacity to be able to do so.”

Credit rating agency S&P published a new report on NSW during the week, forecasting a more rapid return to an operating budget surplus in 2023. 

“NSW's operating balance will revert to surplus relatively quickly ,” S&P commented, noting that its forecasts assumed delays in infrastructure roll-outs due to the tight labour market and supply-chain rigidities.

There is now a prospect that Treasurer Matt Kean and Premier Perrottet—or a future Labor Treasurer in the form of Daniel Mookhey—win back NSW’s AAA rating, reducing interest repayments on NSW’s $109 billion of taxpayer debt, which has exploded from less than $40 billion in 2018.

This will rely on NSW continuing to use the $15 billion left in its Debt Retirement Fund to reduce public debt (after the first tranche of $11 billion of repayments are completed), and then replenishing this inspired fiscal buffer with future asset sales and/or cash (not operating) budget surpluses.

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Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs over $8 billion with a team of 40 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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