Queensland region construction supply and demand analysis: and quarterly indicators to June 2016

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1 Queensland region construction supply and demand analysis: and quarterly indicators to June 2016 A report for the DEPARTMENT OF HOUSING AND PUBLIC WORKS Prepared by the National Institute of Economic and Industry Research (NIEIR) ABN: Queens Parade, Clifton Hill, Victoria, 3068 Telephone: (03) ; Facsimile: (03) admin@nieir.com.au August 2014 PJB1151-QDH&PW-Annual report/qlddpw/2014/july

2 While the National Institute endeavours to provide reliable forecasts and believes the material is accurate it will not be liable for any claim by any party acting on such information.

3 Contents Page no. Executive summary 1. Introduction 1 2. The economic outlook for the world, Australia and Queensland The world economic outlook Political risk Economic policy The permanent loss of capacity When will interest rates rise The Australian economic outlook Gross domestic product The balance of payments Household savings ratio Employment and unemployment Inflation and wages Interest rates The exchange rate Population The Queensland economic outlook Queensland housing affordability Queensland construction activity in the Australian context Queensland construction: The headline outcomes Total construction: A comparison with last year s Annual Report The Queensland dwelling market New dwelling construction Other dwelling expenditure Total Queensland private dwelling construction expenditures Dwelling commencements Non-residential building Private non-residential building Public non-residential building activity Major Queensland non-residential building projects Total non-residential building activity Engineering construction Engineering: The segment drivers Mining investment and output Engineering construction: The outlook Major Queensland engineering projects Queensland s construction share of total Australian construction 39 i

4 Contents (cont.) 3. Continued Page no. 3.7 The regional dimension Brisbane Gold Coast Sunshine Coast West Moreton Wide Bay/Burnett Darling Downs South West Fitzroy Central West Mackay Northern Far North North West Queensland construction: Resources, capacity and price pressures Utilisation of capacity Labour shortages Queensland construction sector unemployment rates Construction cost inflation Quarterly profiles 117 Appendix A: Additional annual tables 126 Appendix B: Additional quarterly tables 139

5 List of tables Page no. E.1 Australia and Queensland gross product and construction activity indicators vii E.2 Annual growth and % contribution to construction activity by major construction segment vii E.3 Construction activity by Queensland region viii E.4 Share of total construction activity by Queensland region viii E.5 Total construction average annual growth rates by Queensland regions ix E.6 Drivers of construction growth by Queensland region ix E.7 Shortage of construction labour by Queensland region x E.8 Queensland construction industry real quarterly price growth at annual rates x 2.1 Formation of Queensland Gross State Product Formation of Queensland population Average annual population change by region Housing Brisbane City Housing Gold Coast Housing Sunshine Coast Housing West Moreton Housing Wide Bay-Burnett Housing Darling Downs South West Housing Fitzroy Central West Housing Mackay Housing Far North Housing North West (a) Australia and Queensland construction industry activity (b) Australian construction industry activity (a) Queensland construction industry activity (b) Fiscal year construction activity growth rates Queensland CVM 3.2(c) construction activity indicators 44 Fiscal year construction activity indicator contribution to total Queensland construction growth rate Annual growth and % contribution to Queensland construction activity by major construction segment Sector contribution to Queensland engineering construction growth Formation of construction in Brisbane Formation of construction in Gold Coast Formation of construction in Sunshine Coast Formation of construction in West Moreton Formation of construction in Wide Bay/Burnett Formation of construction in Darling Downs Formation of construction in South West Formation of construction in Fitzroy Formation of construction in Central West Formation of construction in Mackay 103

6 List of tables (cont d) Page no Formation of construction in Northern Formation of construction in Far North Formation of construction in North West Total construction: average annual growth rates by Queensland regions Drivers of construction growth by Queensland region Contribution of each region to Queensland construction growth Unutilised capacity in Queensland construction sectors Construction industry employment by Queensland regions Queensland regional construction excess capacity utilisation rates Queensland regional construction excess demand Queensland regional construction labour shortage (+) or surplus ( ) Regional construction industry employment by segment Value of work done: Residential new construction (including major additions) by region Value of work done: Non-residential building by region Value of work done: Residential other renovations by region Value of work done: Residential building by region Value of work done: Total engineering construction activity by region Value of work done: Total construction activity by region chain volume measure reference year ($ million) Value of work done: Total construction activity by region chain volume measures reference year Qtr = Queensland construction industry Shortage of construction labour by Queensland region 125 A.1 Total regional population 127 A.2 Share of regional population in total Queensland population 127 A.3(a) Total Queensland construction by region share of residential activity in total regional activity 128 A.3(b) Total Queensland construction by region share of non-residential activity in total regional activity 128 A.3(c) Total Queensland construction by region share of total engineering activity in total regional activity 129 A.4 Share of public expenditures in regional total expenditures 129 A.5(a) Queensland construction by region share of public residential expenditure in total regional residential expenditure 130 A.5(b) Queensland construction by region share of public non-residential building expenditure in total regional non-residential building expenditure 130 A.5(c) Queensland construction by region share of public engineering in total regional engineering expenditure (including Commonwealth) 131 A.6 Queensland regional construction value of work done: chain volume measure Private housing expenditure on new construction and alterations (excluding other work done) 131 A.7 Queensland regional construction value of work done: chain volume measure Public housing 132

7 List of tables (cont d) Page no. A.8 Queensland regional construction value of work done: chain volume measure Non-residential building private 132 A.9 Queensland regional construction value of work done: chain volume measure Non-residential building public 133 A.10 Queensland regional construction value of work done: chain volume measure Private engineering 133 A.11 Queensland regional construction value of work done: chain volume measure Public engineering 134 A.12 Queensland regional construction value of work done: chain volume measure Non-residential building total 134 A.13 Queensland regional construction value of work done: chain volume measure Engineering total 135 A.14 Queensland regional construction value of work done: chain volume measure Total residential (excluding other work done) 135 A.15 Queensland regional construction value of work done: chain volume measure Total public sector engineering (including Commonwealth) 136 A.16 Queensland regional construction value of work done: chain volume measure Private residential (other work done) 136 A.17 Queensland regional construction value of work done: chain volume measure Total construction 137 A.18 Queensland regional construction value of work done: chain volume measure Total construction expenditure share of State total 137 A.19 Queensland regional dwelling units commenced Total residential units 138 B.1 Private dwelling value of work done: new construction (including alterations and additions) 140 B.2 Private dwelling: other value of work done 141 B.3 Private dwelling: total value of work done 142 B.4 Private non-residential building value of work done 143 B.5 Public non-residential building value of work done 144 B.6 Total non-residential building value of work done 145 B.7 Public sector engineering value of work done 146 B.8 Private sector engineering value of work done 147 B.9 Total engineering value of work done 148 B.10 Public dwelling value of work done 149 B.11 Total construction: value of work done 150 B.12 Total dwelling units commenced 151

8 List of figures Page no. E.1 Australian GDP and Queensland GSP vi 2.1 World Real GDP growth rate Nominal and real wages growth and CPI inflation rate Employment growth and unemployment Queensland dwelling new construction approvals ($ million) Queensland dwelling new construction approvals (number) Queensland non-residential building approvals Real Queensland established house prices Queensland housing rental vacancy rate Queensland housing approvals Queensland Private non-residential building work done and private non-residential building approvals Excess demand for dwellings Queensland Queensland share of national population increase and national approvals Queensland non-residential building approvals and work done Queensland non-residential projects under construction, committed and under consideration Queensland mining, LNG and metal ore investment Queensland real mining output % rate of growth Queensland mining investment LNG expansion Queensland engineering work done Queensland total engineering work yet to be done Queensland engineering projects under construction, committed and under consideration Share of public engineering in total engineering Share of Queensland construction industry in GSP Queensland non-residential construction and private non-residential building expenditure share in GSP and GSP growth Queensland regional construction value of work done Brisbane Queensland regional construction value of work done Gold Coast Queensland regional construction value of work done Sunshine Coast Queensland regional construction value of work done West Moreton Queensland regional construction value of work done Wide Bay-Burnett Queensland regional construction value of work done Darling Downs Queensland regional construction value of work done South West Queensland regional construction value of work done Fitzroy Queensland regional construction value of work done Central West Queensland regional construction value of work done Mackay Queensland regional construction value of work done Northern Queensland regional construction value of work done Far North Queensland regional construction value of work done North West Unused capacity in Queensland s construction sector Real construction costs versus labour shortage Annual growth in Queensland construction employment 111

9 Executive summary A review of the core findings As in the two previous annual reports, Australia s economic growth is projected to be relatively strong over the 2015 to 2018 period, with Queensland economic growth higher than the Australian growth. The reason for this expectation is the contribution of: (i) (ii) (iii) current low interest rates which could go lower; an exchange rate that is tracking down to levels with Australian cost competitiveness established (an exchange rate of around 70 cents to the US$); and recovery in house prices and reductions in household debt to income ratios increase net household wealth, will increase dwelling expenditures and household consumption expenditure. For Queensland economic growth, as measured by gross state product (GSP), growth is returning to more normal levels. Dwelling construction is recovering as the accumulated population growth puts pressure on dwelling stock. Employment is slowly growing. Looking forward there are opportunities on the horizon that should ensure that employment growth remains positive. Queensland s LNG construction is winding up and LNG is now heading into the production phase. However the fall may not be as hard. This phase will require ongoing reserves of gas, and the search and development of these gas fields will ensure an ongoing level of engineering construction. There is currently over $20 billion worth of mining projects being considered for the Galilee basin and some $30 billion worth of future projects relating to the port of Gladstone including LNG, rail and port facilities. If even some of these continue to the construction phase there will be a significant softening of the landing. Queensland was badly affected by the Global Financial Crisis, hence the economy and in particular the construction sector is poised to catch up by clearing the back log of delayed projects. i

10 1. Currently (as measured by the indicators of the March Quarter 2014) the growth rate of the world is 3%. The world has only recovered slowly from its recessionary trough rate of growth of 2% at the end of 2012 which occurred because of the withdrawal of the stimulus policies put in place post As was the case in the previous annual report there is a further downgrading of the world economic outlook following the rule that the longer the world takes to recover from the GFC the lower will be the medium to longer term growth rate. This is because the greater the fall will be in capacity in place relative to demand as low levels of investment steadily reduce the excess capacity that was created in 2009 by the severe recessions of that year. This in turn means the lower the scope authorities will have to stimulate activity. Thus instead of the near 4% growth in world GDP expected in 2016 this has now been reduced to the middle of the 3 to 4% range. Over the longer term other factors such as political risks in Eastern Europe, the Middle East, and East Asia which are already starting to impact in a negative way on growth especially in the Euro zone will extend to the wider world economy. As a result post 2016 world economic growth is expected to stay within the 3% to 3.5% range. World growth is still likely to accelerate over the short-term due to market based recoveries as the excessive debts and excess capacity created by the GFC slowly recover to more normal levels. Secondly the high unemployment rates and especially increasing youth unemployment rates are forcing policy authorities to search for ways to stimulate economic activity. The economic conditions indicators for the European and North American economies as at third quarter 2014 are encouraging. For the IFO World Economic Survey business expectations for the next six months are the highest since the pre-gfc period. This result is mainly due however to higher North American expectations with European expectations stable in the sense of only modest growth from current levels. Housing markets have been slowly recovering at least in terms of established house prices. In short, confidence is slowly returning which indicates that the large liquidity overhang prevailing in developed countries because of policies of quantitative easing will in part be translated into increased expenditures. Many of the developing and emerging economies will continue to expand at satisfactory growth rates. 2. Provided China continues to grow at, at least, moderate growth rates (that is, in excess of 6%), then Australia will not meltdown with a financial/balance of payments crisis as would otherwise have been possible given the world difficulties. There are macroeconomic imbalances in the Chinese economy especially in relation to debt excesses that drove house prices upwards over the past three years. House prices are now falling creating a negative wealth effect on consumer demand. However the powerful instruments available to the Chinese government means that a reasonable trend rate of growth will be maintained. However in relative terms Australia is likely to become less important as a supplier of imports. The current Western consensus on the need to rebalance the Chinese economy by rapidly reducing investment and increasing consumption is overstated along with the contention that China has a severe debt problem. Chinese investment ratios are high being what were required for a growth rate of 10% per annum with the expectation now the Chinese planners will target a growth rate of around 7% per annum. Investment as a share of GDP will fall but less than towards the 30% to 33% range consistent with a growth rate of 6.5% to 7% per annum. This is because the Chinese economy faces considerable obstacles to growth not least being the environmental constraint to growth which will require considerable capital deepening rather than capacity expansion in terms of the investment effort. ii

11 In terms of debt given that the debt is to a large extent between the government, the banks and companies that are owned by the same effective entity, the State, large-scale debt cancellation is always available if the problem started to adversely affect growth. For a country with large international assets rather than international debts any domestic debt issues can easily be neutralised by recapitalisation by the central monetary authorities. Debt levels in the private sector will constrain growth as the Government attempts to educate the citizens of the consequences of excessive debt. Perhaps the biggest threat to the Queensland economy from China is not the overall growth outlook but the risk that coal usage quotas will be imposed as an antipollution measure. Provided the Chinese government act rationally by not discriminating against low cost foreign suppliers (that is discriminating in favour of local producers), then at least over the mediumterm this risk to Queensland could be low. Longer term though it is likely to become an issue. 3. After reaching 300,000 over the 2008 and 2009 period, Australia s immigration intake fell to 170,000 in Over 2012 to 2014 fiscal years Australia s net immigration intake has recovered to around 225,000. The national population growth rate currently is around 1.7%. Over the projection period the national unemployment rate is to rise steadily reaching just over 8% by This will place downward pressure on immigration intake especially after As a result net immigration intake is projected to fall from around 210,000 in 2017 to 170,000 by the end of projection period. The population growth rate will fall gradually to 1.2% by The national net immigration rate is projected to oscillate between 210,000 and 240,000 over the next two to three years to ensure adequate labour supply to the mining regions in Western Australia and Queensland. The national population growth will be 1.5% per annum. However, with unemployment climbing beyond 6% over the next 18 months there will be very little risk that the immigration intake will be higher. In relation to Queensland it is expected that the Queensland population growth rate will accelerate from the 1.8 to 2.0% range of the last three years to towards 2.4% by 2016 or 2017 as immigration increases to support the recovery in employment growth and the rise in established house prices in southern states facilitates relocation to Queensland by older age households. 4. After growing between 4% and 6% over the years prior to the GFC, Queensland s gross state product has averaged 1.1% per annum for the three fiscal years 2009 to The average growth rate of years 2012 to 2014 will be 3.6%. This rate of growth on an average annual basis will be maintained to After that date the rate of growth will decline to the vicinity of 2.7% per annum on an annual average basis. For the national economy the profile is similar except that Queensland GSP growth rate was higher than the Australia GDP growth rate in the pre-gfc period. From 2009 the national economy also slowed but was growing faster than Queensland. For the remainder of this decade the national economy will grow at an average annual rate of 2.4% before declining towards a 2.0% growth rate by the end of the projection period. The main reason for this is the expected for in the terms of trade and the consequent increase the current account deficit which given a stress high international debt will constrain longer term growth. The drivers of a stable Queensland GSP growth rate to 2018 will be the slow recovery in employment growth, a recovery in dwelling markets and rising real established house prices leading to increased household wealth supporting the maintenance of relatively high private consumption growth rates and high mining production growth rates over the middle of this decade flowing from the current high levels for mining investment. iii

12 Provided the growth rate in the world economy is no lower than what has been projected in this report, the rate of mining expansion will slow significantly over the latter part of the projection period. However the rate of expansion although being modestly positive will not be significantly negative thereby preventing a return to the low growth rates of the 2009 to 2011 period. Given the sharp downturn in engineering construction over the next couple of years with the completion of the LNG projects the Queensland growth profile is relatively strong both in absolute terms and relative to the rest of Australia. There are several reasons for this including, first and foremost the catch up effect and recovery from the fact that the Queensland economy was the most adversely affected of all Australian states during the post- GFC period, the projected fall in the currency which will help recovery in the Queensland tourist sector, that the fact that LNG plants have high import content which means that increases in other areas of construction activity only need to be $.50 in the dollar to neutralise the decline in LNG expenditures, the fact that they will be ongoing expenditures to secure gas suppliers for the LNG plants which will have a high local content, the resort to high wealth immigration and the recovery in southern states dwelling prices which will stimulate recovery in the Queensland housing construction market. Indeed it is likely that in future bulletins the outlook for the Queensland housing market will be revised upwards as in this projection there is increasing excess demand for housing over the period. Activity is constrained to affordability issues which if addressed would lead to a greater contribution of economic activity to housing than what is the case in this report. Post 2018 issues of access to energy markets in China and India in particular will be important along with the scale of US LNG exports and their prices. At this stage a relative conservative approach has been adopted. 5. Over the past five years, that is, over the period 2010 to 2014, Queensland construction activity has grown by a cumulative 40% or 8.7% per annum. Construction activity has more than doubled in the last decade. This growth, that is, since 2010, has been the result of the expansion of engineering construction expenditure in general, and mining investment (especially LNG investment) in particular. As LNG plants are completed by 2016 there will have to be a general recovery in Queensland s non-resource construction to compensate and simply maintain activity near current levels. This is what has eventuated with the recovery in new dwelling construction. Nevertheless, for every year from 2015 to 2024 of the projection, Queensland s construction activity is below 2014 levels. Averaging 11% below to 2017 and then averaging 7% below through to Over the years 2011 to 2014, Queensland s engineering construction activity increased by an annual average of $5.7 billion a year. The bulk of this increase was driven by private engineering construction. Residential building reduced total construction by an annual average of $0.7 billion, while non-residential building reduced total construction by $0.2 billion. The reverse growth mechanism is projected to be the case over the 2015 to 2017 period. Engineering construction expenditures are projected to contract by an average of $3.7 billion a year, while dwelling construction is projected to expand by an average of $1.5 billion a year. Non-residential building expenditures are projected to expand by $0.2 billion a year. After 2017, engineering construction should contribute an average of $0.5 billion per year to Non-residential building construction is projected to recover modestly with an annual increase between 2018 and 2024 of $0.1 billion annually. Hence by the end of the projection period total Queensland construction activity is 6% below 2014 levels. iv

13 6. Between 2011 and 2014, an average of 75% of the total increase in Queensland construction activity was generated in the Fitzroy region. Mackay, South West, Central West and Darling Downs also experienced an expansion in construction activity, in part because of the gas supply investments associated with the LNG plants being undertaken in these regions. The South East Queensland regions, including Wide Bay-Burnett, all experienced a contraction in construction activity. Over the 2014 to 2018 period the reverse growth mechanism will apply. All South East Queensland regions, including Wide Bay-Burnett, are projected to experience an expansion in construction activity. For Brisbane, the expansion will not offset the falls of the 2011 to 2014 period. For the South West the expansion of the 2011 to 2014 period is countered by the larger contraction of the 2014 to 2018 period resulting in a net contraction over 2011 to Combining the regions the net effect for the period 2011 to 2018 for Queensland is an expansion for total construction of $10 billion. Over the 2017 to 2024 period construction activity in the Fitzroy region is projected to expand by $0.2 billion a year, which will equal the average expansion in Queensland construction activity. Central West, Northern, Far North, South West and Sunshine Coast will all experience contraction over 2018 to For the period 2000 to 2009 Brisbane was responsible for an average of 43% of total Queensland construction activity. By 2014 this had fallen to 27%. For the same historical period the Sunshine Coast and the Gold Coast were responsible for 23% of total Queensland construction activity. By 2014 this had fallen to 12%. Through 2000 to 2009 Fitzroy and Mackay were responsible for 10% of total Queensland construction activity. By 2014 this had increased to 38%. The South West has gone from under 1% to 4%. The changes to this distribution by 2016, or even 2024, will be marginal. The Brisbane share of construction will increase to 28% and 30% by 2024 and the Sunshine/Gold Coast shares are 14% and 16% respectively by The Fitzroy/Mackay shares will be 33% and 28% respectively by The resources boom has permanently changed the structure of construction activity in Queensland. In 2024 Brisbane s construction activity is projected to be 11% above 2014 levels, while the increase for the Gold Coast and Sunshine Coast is predicted to be 38% and 14% respectively. Construction activity in the Darling Downs is projected decline by 19%, with the falls in Fitzroy and Mackay being 30% each. Northern and Far North construction activity is projected to increase from 2014 levels by between 25% and 32%. v

14 Figure E.1: Australian GDP and Queensland GSP 120 Annual % change Australia Queensland vi

15 Table E.1 Australia and Queensland gross product and construction activity indicators Average Gross product Australia ( =100) Queensland ( =100) Dwelling expenditure Australia ( = Queensland ( =100) Non-residential building expenditure Australia ( =100) Queensland ( =100) Engineering construction Australia ( =100) Queensland ( =100) Total construction expenditure Australia ( =100) Queensland ( =100) Table E.2 Annual growth and % contribution to construction activity by major construction segment Annual percentage rate of change (%) Dwellings Total non-residential building Total engineering construction Total construction Contribution to total construction growth (%) Dwellings Total non-residential building Total engineering construction vii

16 Table E.3 Construction activity by Queensland region = Average Brisbane Gold Coast Sunshine Coast West Moreton Wide Bay/Burnett Darling Downs South West Fitzroy Central West Mackay Northern Far North North West Queensland Table E.4 Share of total construction activity by Queensland region (%) Average Brisbane Gold Coast Sunshine Coast West Moreton Wide Bay/Burnett Darling Downs South West Fitzroy Central West Mackay Northern Far North North West Queensland viii

17 Table E.5 Total construction average annual growth rates by Queensland regions Brisbane Gold Coast Sunshine Coast West Moreton Wide Bay/Burnett Darling Downs South West Fitzroy Central West Mackay Northern Far North North West Queensland Table E.6 Drivers of construction growth by Queensland region (average annual $m change between span years) Dwellings Nonresidential construction Engineering Dwellings Total construction Nonresidential construction Engineering Total construction Brisbane Gold Coast Sunshine Coast West Moreton Wide Bay/Burnett Darling Downs South West Fitzroy Central West Mackay Northern Far North North West Queensland ix

18 Table E.7 Shortage of construction labour by Queensland region number (shortage is denoted by +/surplus -) Average Brisbane Gold Coast Sunshine Coast West Moreton Wide Bay/Burnett Darling Downs South West Fitzroy Central West Mackay Northern Far North North West Queensland Table E.8 Queensland construction industry real quarterly price growth at annual rates (%) Sep Dec Mar Jun Sep Dec Mar Jun Sep. Average and Actual Forecast Non-residential building Residential building Engineering construction Total construction x

19 1. Introduction This study has the following objectives: (i) to undertake an historical analysis of Queensland regional construction activity over the 1990 decade to 2013; (ii) (iii) to project Queensland regional construction activity to 2023; and to analyse both historically and to project the capacity of Queensland regions to meet construction demands. The Queensland regional analysis is undertaken at the Australian Bureau of Statistics Statistical Division level. Section 2 overviews the Australian and Queensland economies for the next few years. Section 3 analyses the construction sector from the national, Queensland and Queensland regions perspective. Section 4 analyses capacity utilisation and cost pressures in the Queensland construction sector as well as by region. There are two very important points to remember when reading the text. There are no nominal values used in the study. All dollar million or dollar billion values referred to are in constant prices or technically CVM prices which in this report is the prices of the fiscal year. Also in terms of the domestic economy the calendar years are not in general referred to unless otherwise explicitly noted. That is all years are fiscal years so 2013 would refer to the fiscal year. The exception is for the world economy section where all years referred to are calendar years. An additional set of indicators, namely housing commencements, which are included in the appendix, is added to this report. 1 1

20 2. The economic outlook for the world, Australia and Queensland This chapter is divided into three segments. Each segment considers the macroeconomic environment for the world, Australia and Queensland. 2.1 The world economic outlook Six years after the GFC the uncertainty surrounding the medium-term direction of the world economy is perhaps, except for 2009, at its highest point. The issues are straightforward. This uncertainty is manifested in the range of opinions in answers to the following questions. Will the world economy accelerate over the next 2 or 3 years as has been the long-term expectation? Will growth stay near current levels with rising unemployment and increasing political instability? When will interest rates start increasing from current low levels with negative real interest rates prevailing in a number of economies and do policies have to change, and change to what, if the world, that is the developed world in particular, is to accelerate its economic growth? Has there been a fundamental economic and political structural change in the world economy which must be addressed if growth is to return to near pre-2009 levels? In many countries firm profitability has returned to pre-2009 levels but investment effort remains very weak, thereby being a significant constraint on growth. Reasons for this are advanced below. The impact of austerity policies are clearly seen from inspection of the world GDP quarterly growth rate profile. At the height of the stimulus introduced in response to the GFC world economic growth peaked at 5% at the end of The withdrawal of stimulus saw the world GDP growth more than halved to a trough rate of 2% at the end of Since then world GDP growth has slowly recovered reaching 3% at annual rates in early Political Risk One factor that now is getting attention, and which has been stressed in these reports over the last few years, is increasing uncertainty and thereby weakening the incentive to invest because of the deterioration in the geopolitical outlook. There is no doubt that the fallout from the Ukraine crisis and the continual threat of Russian invasion given the build-up of armed forces on the Ukrainian border has been a major factor in weakening the EU economic recovery over the course of the last 6 months. The fact that Russia contributes approximately a third of Western Europe s gas supply, which could be cut off at a time of crisis with large economic damage, would be a factor weighing on the timing and scale of investment decisions. The current round of tit-for-tat sanctions and likely increase in the scale of sanctions is another factor reducing the short-term appetite for investment. Unless there is a change in Russian leadership and the strategic objectives of the Russian Federation it is difficult to see how a continual decline in the security risks for Western Europe can be avoided, representing a partial return to the political economy of pre

21 In North Asia the continuing disputes over islands, which is driven by the wider issue of the control of the China Sea, will not go away and can only intensify as China s military build-up continues. In 2014 China have 50 significant naval vessels under construction, including the construction of at least one large scale aircraft carrier and two smaller carrier assault vessels. Hardly a week passes without some close encounter between Chinese military aircraft and vessels and those of Japan, the United States, or Vietnam. It is difficult to see how the deteriorating strategic outlook in North Asia is going to be resolved, other than a sharp acceleration in the arms race between China and the rest of Asia which, if continued, could easily evolve into a post 1947 Cold War trade block regime that characterised Europe until The problem here is that unlike Russia in 1947 China is now the world s largest trading power with extensive links to almost all countries. In 1947 Russia s links outside its sphere of influence were very weak. At the very least, over the next decade it is likely the trading relationships between Australia and China will become more political, uncertain and volatile. It s becoming clearer, as has been stressed in these reports in the past, that Australia has entered a long-term period where its external economic and political relationships are going to be dominated by very dangerous currents indeed. It is the declining longer term geopolitical outlook which is the main reason for the weak economic outlook for the world economy post

22 2.1.2 Economic Policy What economic policies are pursued to accelerate the growth in the world economy have a critical importance for Australia, not just because of the level of activity in the world economy, but because of the likelihood of the timing of the increase in world interest rates which will have major consequences for the Australian exchange rate and, therefore, the competitiveness of the Australian economy. With reversal of the post-2008 stimulus policies over 2011 and 2012 the main developed world policy stance has been one of austerity. By this is meant consolidation of fiscal policy deficits so as to stabilise, at the very least, the increase in the debt to GDP ratios. The central idea of this was that growth would be stimulated by the confidence this would give to the private sector that they would not be crowded out by public sector demands, low risk of future taxation rate increases, and interest rates being kept relatively low. It is clear that almost all this policy stance will not lead to acceleration in growth in the foreseeable future. This is despite policies of so-called quantitative easing, whether central bank wise-up private sector asset backed securities to increase liquidity in the economy, lower interest rates and increase established asset prices in the hope of wealth effects and lower cost of capital stimulating investment. In short, monetary policy has now limited effectiveness because interest rates are at minimum levels. This situation was well documented in the 1930s as described by the textbook Keynesian liquidity trap. Private sector investment has failed to respond for the simple reason that excess capacity remains high in most developed economies and, therefore, there are limited investment opportunities. Austerity policies have contributed to this by reducing demand and therefore capacity utilisation rates from levels that otherwise would have prevailed. The objective of controlling government debt, in terms of liquidity impact on the economy, has lost credibility because real interest rates are negative in a number of key economies, implying that nominal interest rates are as low as they can go. Excess liquidity is doing no damage to the world economy in terms of current inflation outlooks. It is clear that if governments simply continued borrowing from the central bank by printing money and spend on infrastructure to drive demand over the last 2 or 3 years, there would have been no increase in net government debt (central banks are part of the general government sector), no increased interest costs (since the central banks give back the interest paid to them to the government) and a significantly less increase in overall liquidity in the economy (measured by the size of the central bank balance sheets) than what has occurred under qualitative easing policies. This is not to mention the key point that for many countries underlying capacity installed would have been considerably reduced relative to demand, which would have been particularly important for the United States with a rapidly deteriorating infrastructure capital stock. These simple points are now being more widely recognised, especially amongst the institutions that matter in setting the framework for economic policy in developed economies. That is, the IMF and the European Central Bank. In an important speech to the meeting of central bankers in Jackson Hole, Wyoming, in late August 2014, the head of the European Central bank called for greater reliance on fiscal policy to drive European economic recovery. How the German objections to this strategy can be overcome only time will tell, though rising youth unemployment rates which will trickle down into the unemployment rates of those aged between 25 and 34 over the next few years will be a powerful political stimulus to find a way through the political obstacles. The issues are, however, more complex than simply the effectiveness of monetary policy vis-a-vis fiscal policy. This revolves around the answer to the question of why central banks have persisted with quantitative easing despite interest rates being at minimum levels, even though the ECB has introduced negative interest rates on bank deposits at the ECB. The answer to this is that central banks have been targeting the exchange rate attempting to stimulate growth by a lower currency. 4 4

23 Unfortunately, when all the major developed economies embark on such a policy its effectiveness is blunted with the exception of winning market share from smaller countries such as Australia, which continue to target the inflation rate rather than the exchange rate and, therefore, continue to have over-valued currencies, stagnant price sensitive non resource exports and increasing import penetration. It is assumed that there is, in Europe at least, a shift in emphasis from monetary policy to fiscal policy. However the shift is likely to be slow, only having a gradual impact on accelerating growth with the impact being noticeable at around The permanent loss of capacity The cost of the GFC is increasing with each passing year. For 2015 the estimate is that the loss and potential output, that is, compared to the likely values that would have prevailed in 2015 if pre-2009 potential growth rates had been maintained, is estimated at 11% for the Euro area, 5% for the United States, 10% for Japan and 12% for the United Kingdom, giving a core developed world total of 8.5%. More importantly, because of the decline in investment over this period, the actual new capacity by 2015 is estimated at 2% for the Euro area, 2% for the United States, zero for Japan and zero for the United Kingdom. This result is because actual capacity installed in 2015 will be much lower than what would have been installed if pre-2009 growth rates had been maintained. If these estimates are correct it indicates the capacity by the policy authorities to grow demand to stimulate their economies. This feature is built into the projections of this report. More importantly, the post-2009 outcomes are also likely to have reduced the underlying growth in potential output because of lower rates of innovation, lower rates expenditure on R&D, decaying workforce skills of those forced into the long-term unemployment, and lower productivity growth rates stemming from simply lower growth overall as economies of scale and scope that otherwise would have been achieved have not materialised. It has been estimated that the underlying capacity growth rate has fallen from 2% to 1% in the Euro area, 1.4% to 0.8% for Japan, 2.6% to 2.2% for the United States and 2.7% to 1.9% for the United Kingdom. These declines were lower than the longer term potential of the world economy, as is captured in the longer-term projections for these economies in the attached table When will interest rates rise the use of macro prudential tools? What is now widely recognised is that the worst possible thing for the developed world economies would be to increase interest rates to correct for sector imbalances, such as rapidly increasing established house prices. To avoid this there is increasing interest in using so-called macro-prudential tools to leave interest rates unchanged, but still act to correct imbalances such as overheated housing markets. Macro-prudential tools represent no more than the use of finance sector quantitative control tools that was common before the 1990s. Use of such tools would be, for example, specifying maximum loan to asset valuation ratios (that were lower than current practise), maximum loan periods, and mandated asset allocation rules in relation to mortgage based assets, liquid assets and commercial loans. In mid-2014 the New Zealand central bank applied macroprudential rules to stabilise the domestic housing market. The UK central bank is also slowly expanding the use of such rules. There will be upward pressure on interest rates, however, if, for the only reason that quantitative easing will have to be wound back to avoid large increases in risk in finance enterprise balance sheets. The expansion in quantitative easing has allowed large-scale financial engineering to occur, particularly in derivative markets. As of pre-2008, no-one is sure of what risks are being built up, 5 5

24 especially for investment strategies and products that don t take account of increases in interest rates. It is this fact that leads some to conclude that if left unchecked the current policies will lead to another GFC four or five years down the track. Thus, the expectation is that the withdrawal of quantitative easing in the United States, for example, will force interest rates up over the second half of A poorer economic outlook than what is currently expected may well postpone this into 2016, especially if macro-potential tools are employed to target financial stability. In viewing the current evidence it is likely that the significant upward shift in interest rates will be postponed, at least to the end of 2015 and probably into 2016, with the increase being less than what was previously expected because of the likelihood that key developed economies will resort to quantitative control measures and, secondly, because of the increasing loss capacity in most developed economies relative to pre-2009 trends which will be reflected in steadily increasing real unemployment rates, if not in the headline unemployment rate. Nevertheless, the negative fallout from the ending of quantitative easing and the increase in interest rates is likely to cause economic costs being imposed on both developed and developing economies, simply because of the build-up of excessive debt and risky financial products that have occurred over the last two to three years. These costs will be realised over the 2016 to 2018 period, which is yet another reason for expecting the economic outlook at the end of this decade to be somewhat subdued. The emerging economies that are most likely to be impacted on from the ending of quantitative easing and the rise in interest rates are the so-called Fragile Five economies of: Argentina; Brazil; Indonesia; Turkey; and South Africa. 6 6

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