Review of the Australian Economy 2012–13: A Tale of Two Relativities

Abstract

It is difficult to review the Australian economy without considering the relative performance of two sectors: mining and manufacturing. The rise in the terms of trade, which underpinned the boom in mining, also propped up the Australian dollar, eroding the competitive edge of manufacturing. While investment in mining expanded, many firms in the manufacturing sector struggled to compete internationally and the sector shrank. This is a classic case of ‘Dutch Disease’,1 but the diametrically opposite trend growth in mining and manufacturing had a special implication for states in Australia. Around 70 per cent of mining activity is concentrated in Western Australia and Queensland, while around 60 per cent of manufacturing activity is located in New South Wales and Victoria. Not surprisingly, there were two speeds of growth: a high of around 8 per cent per annum in the relatively less-populated north-west and a low of around 3 per cent per annum in the more-populated south-eastern corner of Australia. Relativities in growth and employment make common national policies difficult to implement as there will be winners and losers. But, 2012 was also the year when confidence in a global recovery waned, growth in China slowed and concerns were raised about the likely persistence of the mining boom. Anxieties about the international economy also dampened consumer confidence and growth in the retail sector was lack-lustre. The Reserve Bank of Australia (RBA) cut the official cash rate three times in 2012, bringing it down from 4.25 per cent in January to 3.25 per cent by November 2012 to help stimulate the economy. Recent economic statistics suggest that activity will remain moderate. Gross Domestic Product (GDP) in the Australian economy grew by 0.6 per cent in the June quarter after surging by 1.4 per cent in the March quarter. Inflation is unlikely to soar as the feared ripple effect of the carbon tax (implemented on 1 July 2012) appears to be unfounded. Growth in employment, however, is likely to be modest in 2012. We expect GDP growth in Australia for the calendar year 2012 to remain around trend, at about 3.4 per cent, and the unemployment rate to languish, at around 5.2 per cent. Underlying inflation rate is likely to stay within the official band of 2–3 per cent. Table 1 contains our estimates for 2012 and forecasts for the year ahead. In this article, we draw attention to the two speeds in the global economy and the likely implications for the Australian terms of trade and the real (nominal) exchange rate. We then provide a round-up of the Australian economy in 2012 and the likely state of the economy in 2013. Concluding remarks are provided in Section 4. Our main point is that the relativities caused by the differential rates of growth in mining and manufacturing will continue, but given their relatively small shares in production and employment, it might be useful to consider value-added services as the next engine of growth and employment. In January 2012, the International Monetary Fund (IMF) expressed grave concerns about prospects for a global recovery because of the increased downside risks associated with the fiscal overhang plaguing many advanced economies (including the Euro area) and the overall negative trade and financial impacts on growth in emerging and developing economies. The IMF's projections of global growth were revised progressively downwards and the latest October report projected a mere 3.3 per cent growth in world output in 2012 and 3.6 per cent in 2013 (down from 3.8 per cent in 2011 and 5.1 per cent in 2010). The global economy is also proceeding at two speeds: low growth in advanced economies, of about 1.3 per cent in 2012 and a projected 1.5 per cent in 2013, and high growth in emerging market and developing economies, of about 5.3 per cent in 2012 and a projected 5.6 per cent in 2013 (Figure 1). Note: Eco. denotes economy. Source: International Monetary Fund (2012a). Europe saw the unfolding of the Greek crisis, which threatened the stability of the Euro zone by highlighting the weakness of a currency union without an accompanying fiscal union. After much drama and deliberations, the European Stability Mechanism was launched in October to replace, eventually, the European Financial Stability Facility as the permanent fund to bail out struggling economies. However, the size of the fund is around €500 billion and it may not be large enough to be effective should trillion-dollar economies like Italy and Spain (with debt-to-GDP ratios of around 120 per cent and 70 per cent, respectively) seek financial help. Meanwhile, across the Atlantic Ocean, the US economy appears to be on the slow road to recovery (Figure 2). More jobs were created in July and August and the unemployment rate has dropped below 8.0 per cent, the lowest level since February 2009. The threat to the recovery process appears to be the fiscal cliff,2 but the devastation caused by Hurricane Sandy on Halloween may shift sentiment towards more, rather than less, fiscal support. Source: International Monetary Fund. The other major advanced economy, Japan, is experiencing the effects of slowing global demand. Growth in both export and import volumes are falling, reflecting both weakening demand in its major trading partners, especially the Euro area and China, and weakening domestic demand. Growth in the volume of world trade is projected to slump to 3.2 per cent this year, from 5.8 per cent last year and 12.6 per cent in 2010 (Figure 3). Japan's growth is expected to stay low. Growth in China is expected to be slower, around 7.8 per cent compared to the double-digit growth rates of previous years. Inflation appears to be well below the official target of 4 per cent. This provides policy-makers with room for further monetary easing to boost domestic demand amid the slowing foreign demand for China's exports. India, the fourth-largest importer of Australian resources (coal, gold, copper ores and concentrates), is also expected to continue to grow. Source: International Monetary Fund. Australia's terms of trade continued to fall in 2012 and, by June 2012, it was 9.2 per cent below its peak of 130.2 in September 2011. The fall was due more to a fall in the export price of commodities than to a rise in import prices (Figure 4). Between September 2011 and June 2012, the export price deflator fell by 6.6 per cent, while the import price deflator rose by 3.0 per cent. Sources: Australian Bureau of Statistics and Reserve Bank of Australia. The fall in export prices can be attributed to a fall in the demand for, and a rise in the supply of, commodities. In 2012, continued weakness in Europe and the United States eroded growth in China and the slower-than-expected growth, in turn, led to weaker demand for commodities. Meanwhile, supply grew due to an expansion in mining capacity around the world. Although the terms of trade fell in 2012, it is still at historically high levels. Furthermore, while the fall can be attributed to falls in the prices for ‘metal ores and minerals’ and ‘coal, coal and briquettes’ (Figure 5), they were counteracted by rises in the price of ‘gas, natural and manufactured’. The key driver of the resource boom may have changed, but it is by no means over. Source: Australian Bureau of Statistics. The appreciation of the Australian dollar began around 2001, about the same time as the terms of trade began to improve (Figure 6). It has been above parity for almost 2 years.3 Since the terms of trade is expected to remain high, the exchange rate is also likely to remain high. Note: LHS denotes left hand side and RHS denotes right hand side. Sources: Australian Bureau of Statistics and Reserve Bank of Australia. The Australian exchange rate was also propped up indirectly by the relatively more expansionary monetary policies adopted in Europe, the United Kingdom, Japan and the United States. Since the official rates in these countries are effectively at the zero lower bound, their monetary policies have been conducted through expansion of balance sheets, which essentially increased their money supply and devalued their currency. The GDP in the Australian economy grew by 0.6 per cent in the June quarter after surging by 1.4 per cent in the March quarter. In the 12 months to June, the economy grew by 3.7 per cent. The main drivers of growth (in seasonally adjusted terms) were: household consumption (0.3 percentage points), government consumption (0.3 percentage points) and net exports (also 0.3 percentage points). The biggest detractor came from the run-down of inventories. We estimate GDP growth in Australia in 2012 to be about 3.4 per cent and forecast modest growth for 2013 of about 3.5 per cent. Household consumption expenditure remains subdued as consumers remain wary about the future. Figure 7 shows the difference between the two sub-components of the Consumer Sentiment Index. The Current Conditions Index provides an indication of consumers' perception of the state of the economy now, while the Expected Conditions Index provides an indication of consumers' perception of the state of the economy beyond a year. A positive (negative) value implies that consumers view current conditions more (less) favourably, compared to the future. There was a brief period of optimism around April 2012, when signs of a weak recovery in the United States and better fiscal consolidation policies in the Euro area lifted the threat of a sharp global slow-down (see IMF 2012b), but this proved to be short-lived. In general, Australian households have been wary about the economy since late 2010. Source: Melbourne Institute. The strength of the resource boom caused a surge in mining investment in the September quarter of 2011 (Figure 8). This is a manifestation of the second phase of the boom (investment to increase supply) following the first phase (increase in price of commodities).4 However, it would be difficult to sustain record investment growth in these times of global uncertainty. Mining investment is expected to peak soon and growth in investment has been revised downwards.5 Source: Australian Bureau of Statistics. The third phase of a mining boom is the growth in exports. The assumption is that more supply will be forthcoming from the expanded mining capacity and that this will translate into exports (Figure 9). In 2013, growth may turn out to be export-led, provided that the advanced economies continue to recover.6 Source: Australian Bureau of Statistics. The GDP provides an estimate of production in the economy and it is usually computed in three ways, taking into account the circular flow linking production, income and expenditure.7 However, since Australia is a trading nation, the income generated, its real purchasing power, is also affected by the relative prices of exports and imports (that is, the terms of trade). When the terms of trade improves, fewer exports are needed to pay for a given volume of imports and this means that an increased volume of goods and services can be purchased by residents out of the incomes generated by a given level of domestic production. This improvement is called the trading gains and losses from changes in the terms of trade. Figure 10 shows the year-end growth in GDP and Gross Domestic Income (GDI) since the floating of the dollar in December 1984. In general, GDP and GDI move together and change by the same amount. But, since 2001, the gains from improvements in the terms of trade have resulted in a higher growth rate for GDI relative to GDP. Source: Australian Bureau of Statistics. The scatter graph in Figure 11 shows a clear positive relationship between the quarterly change in the terms of trade (vertical axis) and the difference between the growth in GDI and GDP (a measure of trading gain). The slope suggests that a 5 per cent improvement in the terms of trade is associated with about a 1 per cent trading gain per quarter (ceteris paribus). Specifically, when the terms of trade improved by 5.1 per cent in March 2010, growth in GDP and GDI were 0.6 per cent and 1.6 per cent, respectively resulting in a trading gain of 1.0 per cent. In December 2011, the reverse happened: the terms of trade fell by 5.1 per cent and growth in GDP and GDI were 0.5 per cent and −0.6 per cent, respectively resulting in a trading loss of 1.1 per cent. Sources: Australian Bureau of Statistics and Reserve Bank of Australia. An observation frequently expressed is that, rather than save part of the pre-Global Financial Crisis (GFC) windfall gain from high commodity prices, Australians reduced their savings and rapidly built up debt, mainly to purchase housing. Recent data suggest that, post-GFC, while there is some evidence of deleveraging by Australian households, the accumulation of housing debt relative to assets is on the rise (Figure 12). This does not bode well for 2013, when the climate of low interest rates will favour a take-up of mortgages. Although house prices in Australia soared pre-GFC, the economy did not collapse. One of the risks in 2013 could well be the resurgence of a housing bubble and should global uncertainty exacerbate the expected fall in the terms of trade, the consequences could be dire. Sources: Australian Bureau of Statistics and Reserve Bank of Australia. The latest Consumer Price Index (CPI) by the Australian Bureau of Statistics (ABS) showed that headline inflation increased by 1.4 per cent in the September quarter, following a 0.5 per cent increase in the June quarter and 0.1 per cent in the March quarter. In the 12 months to September, headline inflation increased by 2.0 per cent. Underlying inflation, as measured by the trimmed mean, is 2.4 per cent (year-end). The ABS release in September was particularly important because it was the first official reading of price changes since the introduction of the carbon tax in July this year. A reading of 1.4 per cent was higher than the market consensus estimate of 1 per cent. While the impact of the carbon tax cannot be identified precisely in the CPI measure, the contributions to the September inflation rate included an increase of 15.3 per cent for electricity (a significant increase, compared with a rise of 6.6 per cent for international holiday travel and accommodation and an increase of 4.5 per cent for hospital services and offsetting price falls of −3.9 per cent for automotive fuel and −1.0 per cent for motor vehicles). Aggregating the quarterly changes of over 87 expenditure classes into the 11 broad groups in the CPI basket (Figure 13), we find that the housing group recorded the largest price rise, of 3.2 per cent, followed by 2.4 per cent for health services.8 Note: Ins. & fin. services denotes insurance and financial services. Source: Australian Bureau of Statistics. Figure 14 shows the break-down of aggregate inflation into that associated with tradeables and that associated with non-tradeables. The high exchange rate is keeping the price of imported goods down, offsetting any cost-push inflation (there is unlikely to be demand-pull inflation, given low growth). Briefly, evidence to date suggests that the expected escalation of prices associated with the carbon tax is unlikely to eventuate and that the high exchange rate is helping to keep inflation low. Source: Australian Bureau of Statistics. The RBA adopted an expansionary stance in 2012, mainly in response to weaker economic conditions and low growth in employment (Figure 15). The official interest rate was cut three times in 2012, totalling 100 basis points (a cut of 50 basis points in May 2012, 25 basis points in June 2012 and 25 basis points in October 2012). The target cash rate is now 3.25 per cent and it is just 25 basis points above the low level of 3.0 per cent in September 2009 (about 11 months after the onset of the GFC and when the RBA lowered the interest rate by 4.25 per cent, from 7.25 per cent in August 2008). Source: Reserve Bank of Australia. There is a non-zero probability that the global economy could collapse in 2013 and the RBA will once again be put in a position where it has to cut rates swiftly to support activity. Behaviour in financial markets appears to support the view that global recovery is still weak. The long rate normally exceeds the short rate by a risk factor to capture future uncertainty, be it lower growth and/or higher inflation. The yield curve (10-year bond rate less 90-day bill rate) has been inverted since August 2011, suggesting that financial markets have factored in a less-than-rosy future (Figure 16). Source: Reserve Bank of Australia. In the event of a global recession, this time around Australia may be joining other nations in hitting the zero lower bound. But, this is a pessimistic scenario and the odds are that the advanced economies will recover. The more pressing question is whether the blunt monetary policy instrument is still effective. There is some evidence that inflation-targeting is an effective stabilisation tool in Australia. The aim of inflation-targeting is to reduce risks associated with inflation uncertainty, but it requires economic agents to have confidence that actual inflation will stay within the official target band. Figure 17 shows that the expectations of inflationary pressures appear to be low and that the expected inflation rate (based on a monthly survey of 1,200 households) is relatively stable (varying between 3 per cent and 4 per cent). More importantly, wage growth has been modest and so a vicious wage–price spiral is a remote possibility. Sources: Australian Bureau of Statistics and Melbourne Institute. For monetary policy to be effective, it is also important for changes in the cash rate to be transmitted quickly to other rates and, moreover, that the ensuing levels and spreads are of magnitudes that cause changes in real expenditures. The banking sector has an especially important role in the transmission of monetary policy. Cuts in the cash rate tend not to be fully passed on by banks for various reasons (for example, increased funding costs).9 A recent example would be that, between January 2012 and October 2012, the official rate was cut by 100 basis points, but the deposit rate fell from 4.2 per cent to 3.5 per cent, while the standard variable mortgage rate fell from 6.85 per cent to 6.25 per cent. Be that as it may, in general, interest rates move in tandem with official rates. Policy can also be implemented via changes in quantities; namely, the volume of lending. Credit growth is still weak, especially lending for housing, but there are signs of a rebound in bank lending for business (Figure 18). Source: Reserve Bank of Australia. The national unemployment rate increased from 5.1 per cent in January 2012 to 5.4 per cent in September 2012. Over this period, the economy added around 98,000 jobs, consisting of 60,000 full-time and 38,000 part-time jobs. Table 2 provides information about full-time and part-time job creation at the industry level. In the last 2 years, the three top job-creating industries were mining (73,000 jobs), health care and social assistance and and services jobs), while the three top industries were manufacturing jobs), and and The high of full-time to part-time in mining is but there is no change in the of full-time to part-time ratios over the last 3 years. creation in 2012 was better than in 2011 net job was but it is still weak compared to job growth in the market conditions have but not to levels (Figure Source: Australian Bureau of October 2012. the in job in the last 3 post-GFC, the unemployment rate has been relatively stable between per cent and 5.4 per cent). One is the creation of part-time was particularly important in but the main for the small in the unemployment rate with the change in the has been since 2011 (Figure Note: LHS denotes left hand side and RHS denotes right hand side. Source: Australian Bureau of October 2012. The in the aggregate rate appea

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