Australia: Positive in the near term, but a blurred horizon Asia Pacific Economic Outlook, Q3 2016

GDP growth for Q1 2016 was the highest recorded since Q1 2012, driven mainly by exports and household consumption. Business investment in engineering construction and new buildings, however, fell sharply. This reliance on exports over investments makes the economy susceptible to external shocks, a cause for concern in the future.

After registering annual growth of 2.5 percent in 2015, GDP surged in Q1 2016 as the economy grew 3.1 percent year over year. This is the fastest growth recorded in a quarter since Q1 2012, driven primarily by strong exports and household consumption (these two components of GDP have lately been the key growth drivers of the economy). On the other hand, business investment in engineering construction and new buildings fell sharply.

A higher volume of iron and liquefied natural gas exports supported growth, offsetting the impact of lower commodity prices. A decade-long mining investment is now bearing fruit as exporters are able to continue production at low costs and maintain high profits despite falling prices. In addition, a steady depreciation of the Australian dollar has improved export competitiveness and boosted exports. Trade in services exports, which grew 15.8 percent year over year in Q1 2016, has benefitted from the falling value of the currency. Tourism, health care, and education were the key drivers of the improvement in the services sector balance.

Growth in investment has been in the negative territory since Q1 2013 and shows no sign of recovery anytime soon. In fact, the contraction is turning bigger with every passing quarter.

The recent appreciation of the Australian dollar since the beginning of this year may impact exports in the current quarter. However, the value of the currency is expected to reverse in the second half of the year. China’s economic slowdown and continued low commodity prices, together with the Fed’s decision to hike policy rates, will likely put downward pressure on the Australian dollar.

Strong employment numbers and rising house prices increased household wealth and facilitated higher household consumption expenditure and residential housing construction. Household consumption grew at a robust pace of 3.2 percent year over year, while dwelling investment grew 7.2 percent in Q1 2016.

On the other hand, private business investment continued to contract sharply in the March quarter. Growth in investment has been in the negative territory since Q1 2013 and shows no sign of recovery anytime soon. In fact, the contraction is turning bigger with every passing quarter. Investments in non-mining sectors have failed to compensate for the slack created by falling investments in the mining and energy extraction sector.

Inflation has eased lately since we last visited the economic outlook of Australia, reflecting the impact of low oil prices; appreciation of the Australian dollar leading to dampened import prices; and subdued domestic price pressures. The Reserve Bank of Australia (RBA) has also slashed its underlying inflation forecast to 1–2 percent in 2016 and 1.5–2.5 percent in 2017 during its release of the quarterly statement on monetary policy.1

Policy actions and challenges to outlook

Falling prices, weakening business investments, and an appreciating currency prompted the RBA to cut policy rates in May 2016. With inflation expected to remain low, further interest rate cuts are still on the cards this year. By bringing down the cash policy rate to an unprecedented low of 1.5 percent, the bank intends to boost the credit cycle and raise consumption demand. This may help the economy rebalance as it gradually transitions away from the investment to the production phase of the mining boom.

But the economy faces some inherent challenges, and monetary policy interventions may not be sufficient to tackle those. Evidently, the economy is highly reliant on exports for growth rather than investments, which makes it susceptible to external shocks. Moreover, commodities are the biggest exported item, which makes exports vulnerable to international commodity prices. Lower commodity prices can potentially impact Australia’s GDP through a fall in the terms of trade, and can weaken export revenues, wage growth, and government revenues. At the same time, lackluster business investment may hinder growth in the medium and long term.

Historically, growth in GDP has improved employment as well as wages. However, in the past few quarters, robust economic growth has failed to generate strong income growth, as a result of which income earned by households has come under pressure. This does not bode well for future household consumption spending.

Overall, the RBA expects GDP to grow 2.5–3.5 percent over the year to December 2016, and to increase to 3–4 percent over the year to June 2018, which is above the estimated potential growth of the Australian economy.2 However, if the economy does not transition away from export-led growth soon and if wages continue to remain stagnant, Australia may find it difficult to achieve these growth expectations.