Project LINK Meeting New York, - October 1 Country Report: Australia Prepared by Peter Brain: National Institute of Economic and Industry Research, and Duncan Ironmonger: Department of Economics, University of Melbourne 1. Australian economic outlook for the forecast period. At the centre of the current projections is the mechanism that the balance of payments is going to move back to the centre stage as a determinant of Australian economic growth. It occupied this position in the th Century to the late 198s, until the rapid expansion of world capital flows over the last years appeared to rescue Australia from worrying about its international debt and current account deficit. The sustained high current account deficits and steady built up in foreign debt, has meant that since the mid 199s Australia s ratio of short term debt (or international debt of less than one year to maturity) to foreign reserves has increased from to 1 to 1 to 1 currently. The optimum ratio for emerging economies is considered to be 1 to 1. Moreover, recent studies have indicated that the best indicator of how badly an economy was affected by the GFC was the reserves to international debt ratio just before the crisis. The lower the ratio the more adversely affected an economy was by the GFC. Australia clearly was one of the exceptions to this general rule. It cannot be assumed that this will remain the case. The next few years will be a difficult time for emerging or developed economies that have a high vulnerability to sudden changes in international investor sentiment. Risk margins demanded by investors over the next 1 years will be higher than the last decade. This means that the Australian economy is likely to generate distinct business cycles over the next 1 years with interest rates peaking over 1-13 and 1-17. During the peak interest rate periods real short term interest rates will be in the region of % to.%. This will be required to attract the foreign capital to roll over Australia s international debt and to attract new capital to cover current account deficits. The interest rate peaks will be followed by periods of slow economic growth, around 1.7% for 13 and.% for 18, with sharp downturns in dwelling activity. Balance of payments pressures will be an important, but not the only, factor in driving interest rates and the economic cycle. The other will be the rate of inflation. The relatively high growth over 11-1 and 1 will push inflation rates to the 3% to % per cent range which will reinforce the upward pressure on interest rates from balance of payments pressures.. Interest rates. The interest rate profile is derived by a Taylor Rule equation which has worked well in explaining interest rates over the last decade. The arguments in the Taylor Rule equation are: (i) the inflation rate; (ii). times the gap between the inflation rate and %; (iii). times the gap between the capacity utilisation rate and nominal or non-inflationary capacity utilisation rates; 1 c:link\link1a.doc
(iv).1 times the gap between the current account deficit as a % of GDP and -.% where the latter is the sustainable level. Australian 9 day interest rates are high compared to most other countries. Australia s rate is approaching % compared to the.% of the US and Japan and.8 per cent for the Euro area. In many countries, unlike Australia, the medium term bond rate, such as the 1 year government bond rate, is the more important indicator of the interest rate benchmark for the rest of the economy. In the case of this indicator the differentials are less. Currently the 1 year bond rate for Australia is %, compared to 3.% for the United States and.8% for the Euro area. The differential is explained by the Taylor Rule drivers. For example, the inflation rate in the US and the Euro area are one half to two thirds of the Australian level. The Greek debt crisis has focussed attention on the ability of countries to service their debts. At first instance it may be thought that the Greek situation is irrelevant to Australia as the focus for Greece was on the ability of the country to finance its public debt. In contrast, Australia has low public sector debt and an annual public sector deficit as a per cent of GDP around a quarter of the Greek level. That is,.% compared to 1% for Greece for 1. The reality is that economic policy in Australia is being applied with a false sense of security. Consider the ratio to GDP of the annual current account (1 months ahead) plus the total foreign debt of 1 months or less to maturity less internal reserves held by the Reserve Bank of Australia. This ratio rose rapidly since the late 199s to reach about % of GDP in March 9. It has fallen back to % of GDP by March quarter 1. However, this decline reflects the recovery of the exchange rate from the lows of early 9. There are a number of points to be made. First, the Australian ratio is very high by international standards. Countries on international debt sustainability watch, such as the countries of Eastern Europe, appear to have comparable ratios at around % to 3%. Second, the ratio is sensitive to the exchange rate because a significant part of Australia s internal debt is in foreign currency. Third, any weakening of confidence of Australia to service its foreign debt could weaken the currency and quickly carry the ratio well beyond the % mark. The basic problem for Australia is that the bulk of the short term debt is held by the banking system. To protect the banking system in an exchange rate crisis the government could be forced to transfer part or all of the bank debt to its own balance sheet and, if confidence was not restored, a good part of medium term debt as well. The focus would then shift to the ability of the government to service the debt. That is, within a very short period of time Australia could go from having one of the lowest ratios of public sector debt to GDP of the high income countries to one of the highest. In the absence of an exchange rate crisis it is clear that at the very least the interest rate margin paid on foreign debt will increase over the next few years, which will place upward pressure on domestic interest rates over and above the level suggested by the standard Taylor Rule equation. That is the.1 coefficient for the current account deficit is increased for this projection. As has been noted above, it is expected that there will be considerable currency instability over the next four to five years. As a result, over 1 to 1 the short term interest rate is projected to peak at in excess of 8% during this time. The high interest rate will be a combination of: (i) inflation rates in excess of 3% and approaching % over 1-13; (ii) (iii) general world high interest rates because of high risk premiums for financial and currency risks; and high margins on Australian debt because of the need to roll over higher levels of short term international debt. 3. Inflation. Currently the underlying rate of inflation in Australia is running at around 3% per annum. This is what would be expected given the growth in unit costs of production in general, and the growth in nominal wages. The inflation rate is at the top of the RBA range for acceptable outcomes. The expectation is that inflationary pressures will intensify over the next two years compared to the current, largely satisfactory, inflation outcome. This is because of: (i) increasing capacity utilisation rates which will enable profit margins to recover or be enhanced as GDP growth is likely to grow faster than the underlying growth in capacity; c:link\link1a.doc
(ii) (iii) (iv) decline in productivity growth as the economy moves towards higher capacity utilisation rates; recovery in oil prices and some commodity prices as the general world growth rate accelerates; potential weakness in the exchange rate leading to the intensification of inflationary pressures; and (v) the high probability of a carbon pricing regime circa 1 or 13, irrespective of the political colour of the government of the day because of strong international pressure. The cycle is then repeated over the second half of the period. The inflation rate, as measured by the CPI, is aggravated by a steadily devaluating weighted average exchange rate over the period. Over the projection period the currency is projected to decline by 3%, adding about % to the cumulative increase in the prime level. High productivity growth requires high GDP growth and it appears that Australia could well be locked into a cycle of relatively low trend rate of growth and a business cycle which discourages firms from investing at the level required to support high growth and high productivity growth. Australia s inability to ensure an adequate skilled labour supply from the resident population is another factor that will contribute to the inflationary problem.. Gross Domestic Product. The Australian GDP growth rate has been revised downwards from previous forecasts. The downward revisions to 1 reflect the more difficult international economic environment that will result from many high income countries exiting from their stimulus programs earlier than expected and the additional pressure that will be brought on Australia to operate within the balance of payments constraint to growth. After 1, the downward growth revisions reflect the fact that Australian households are borrowing annually $ billion to finance consumption expenditure, which will have to end over the next three to four years. When it ends, even with a soft landing over 13-, it will still require around an 8% reduction in household consumption expenditure relative to income. This will have a significant negative impact on GDP growth. The following section outlines why this will have to be the case. Australian households: Debt servicing and consumption The following table shows three indicators for the Australian household sector. The first row of data is the headline net savings rate as defined in the Australian National Accounts. The second row of data shows estimated household savings via superannuation based on the last National Accounts estimate. The third line of data in the table is the difference between the first two lines of data and represents non-superannuation savings by Australian households. It is significantly negative and has been so since the mid 199s. Australian Household Sector - June 199 to December 9 Savings as percent of Net Household Disposable Income Net household savings Jun 9 Jun 9 Jun Jun Jun 8 Dec 8 Mar 9 Jun 9 Sep 9 Dec 9 8.1... 1.1.9..3. 3.7 Household superannuation savings 7.3 1. 7.9 7.8 1. 1.3 9.7 9. 9. 9.7 Non superannuation savings.8 1. 8.1 7. 9. 11. 3..3 3..1 It has long been recognised that Australian savings are low. However, the National Accounts have been deceiving us as to just how low. In countries where payroll taxes are levied to finance government social security schemes, any resulting savings are credited to the government and not to the household sector. In Australia compulsory superannuation contributions are levied which are very similar to payroll taxes, but because they are levied by private bodies they are included in the National Accounts as household savings. Households are thus credited with a savings rate of about 1 per cent of income, which would not be credited in the National Accounts of comparator countries. This means that household non-superannuation savings are well below zero, almost completely offsetting the superannuation savings impact given that net household savings are near zero and have been for some time. It appears from the data in the following table that negative household non-superannuation savings have largely been financed by the build up in the household debt to income ratio. 3 c:link\link1a.doc
Australian Household Sector - June 199 to December 9 Household Debt as percent of Net Household Disposable Income Jun 9 Jun 9 Jun Jun Jun 8 Dec 8 Mar 9 Jun 9 Sep 9 Dec 9 Household debt as % of net disposable income 7. 87. 1.9 138. 19. 193.1 178. 18.9 181. 188. This hypothesis is consistent with two data series. There is a correlation between cumulative household equity withdrawal as a percentage of net household disposable income and the build-up in household debt. (Equity withdrawal is defined as the change in debt less net investment.) There is a close relationship between the change in debt since the mid 199s and the cumulative change in household non-superannuation savings as a percentage of household disposable income, where the latter has its sign reversed. This means that currently the Australian household sector is borrowing approximately $ billion per annum to finance its current level of consumption expenditure. This cannot continue and at some point it will stop with severe implications for the economy. At any time over the next five to ten years household consumption expenditure growth is likely to turn significantly negative. The alternative is a hard landing where the correction takes place over a one year period leading to a contraction in GDP of % to % and a percentage point increase in the unemployment rate. The longer the current situation continues, the more likely this will be the case.. Wages and employment. The employment growth rate is expected to decline relative to GDP growth over the medium term. This is because relatively strong employment growth was maintained over 9 and into 1 by declines in average hours of work. In this context it is worth noting that total hours worked in the March quarter 8 was approximately the same as in the March quarter 1. That is, if total employment had behaved in line with total hours worked, the unemployment rate would have exceeded 7%. It is assumed that as the economy s growth rate increases the average hours worked will increase. That is, employment growth will become relatively weak. The next significant downturn post 1 should result in the unemployment rate increasing to over %. In this context it should be noted that in any case the effective increase in the underlying unemployment rate has been considerably greater than the headline unemployment rate. This is because, as in past downturns, the true increase in the unemployment rate has been disguised by governments shifting working age unemployed from unemployment benefits to other forms of social security support. October 1 c:link\link1a.doc
Project LINK October 1 - AUSTRALIA Calendar Years 9 9 1 11 1 13 1 Aggregate Demand (Current Prices) Percent Change Private Consumption A$b 7..8.. 7... Government Consumption A$b 3..3 8. 9..9..7 Fixed Capital Formation A$b 3.8-1.8 8.7 8. 13.8.1. Exports of Goods & Services A$b. - 9.3 17.9 11. 1.9 9. 1.3 Imports of Goods & Services A$b. -1. 7. 1.. 13. 9.9 Gross Domestic Product A$b 1. 1. 8.8 7.9 9...3 Aggregate Demand (At 7-8 Prices) Percent Change Private Consumption A$b 9. 1.7 3. 3.9 3.7. 1. Government Consumption A$b 11..8.9..8 3.1 3.3 Fixed Capital Formation A$b 33. - 1. 9.3 7. 1. -. -. Exports of Goods & Services A$b 37..9.1 7.9.8..9 Imports of Goods & Services A$b. - 8.3 1.3 1..3 -.. Gross Domestic Product A$b 1. 1. 3. 3. 3.3 1.7. Aggregate Deflators (7-8 = 1) Percent Change Private Consumption 1 3.1.. 3. 3.9 3.8 Government Consumption 17 3.....8 3.3 Fixed Capital Formation 17 -.7 -..9 1. 9.3.3 Exports of Goods & Services 1-1.1 11.1 3..8.3 7.1 Imports of Goods & Services 1-1.8-7. - 1.3 18. 1.1 9. Gross Domestic Product 1.3..1. 3.3. Balance of Payments Percent Change Exports All Goods A$b 181. -13.. 1.7 1.8 1.1 1.9 Imports All Goods A$b 19. -11. 3.9 9. 9. 17.3 11.7 Exports All Goods US$b 1. -19.3 38. 1. 3.3.8.3 Imports All Goods US$b 1.3-17. 17.7 1..8 9. 3.3 Annual Value Trade balance FOB US$b -1.3 17.8 7. - 7.8 -. -.9 Current Account Balance US$b -3.9-7. -33. -81. -11. -9.7 Exchange rate A$/US$ 1. 1.11 1.8 1.1 1. 1.3 Key Economic Indicators Consumer price index (% change) 1.8.9. 3.3.1. Unemployment Rate (%)...1.9.. Treasury Bill Rate (%pa) 3..7. 8. 7.8.9 Bond Rate 1 year (%pa)...3... Government Surplus (A$b) -. -18. -1. - 3. -11. -1. Government Surplus (%of GDP) -. - 1.3 -.8 -. -.7 -.8 c:link\link1a.doc
Project LINK Meeting New York October 1 Charts: Australia Australia Outlook 1-1 Gross Domestic Product Fixed Capital Formation Gross Domestic Product 1 1 8 - - 9.3 3. 3. 7. 1 1 8 - -8 Fixed Capital Formation - 1 3 7 8 9 1 11 1 13 1-1 Australia Outlook 1-1 Unemployment Private Consumption Deflator.. Unemployment 3 1-1. -8.1. -1.. 3.. 1.. -1. Consumption Deflator - 1 3 7 8 9 1 11 1 13 1 -. c:link\link1a.doc
Project LINK Meeting New York October 1 Charts: Australia Australia Outlook 1-1 Private Consumption Government Consumption 7.9 7 3 3. 3.9. 3 1 1 1 3 7 8 9 1 11 1 13 1 Australia Outlook 1-1 Exports G&S Imports G&S 1 1.3 1. 1 1 1.1 7.9 - - -1-1 -1 1 3 7 8 9 1 11 1 13 1-1 7 c:link\link1a.doc