Australia: Shifting the dial toward the long term Asia Pacific Economic Outlook, Q1 2017

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Though Australia experienced strong growth in the first half of 2016, the medium-term growth outlook is worrying because of impending domestic and external risks. The government might have to concentrate on longer-term plans to ensure sustainable growth.

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Australia witnessed strong economic growth (3.1 percent year over year) in the first half of 2016 owing to the recovery in commodity prices; increased government spending on infrastructure; reduced cost of credit, thanks to the Reserve Bank of Australia (RBA), for easy monetary policy; and China’s renewed stimulus to prop up construction activities.1 While all these factors have played out favorably so far, and might even continue to support growth in the short term, the medium-term growth outlook is worrying because of impending domestic and external risks. In other words, Australia has to focus on factors that enable sustainable long-term growth, possibly by restructuring its economy.

Domestic risks edging up

Nonmining sectors lack momentum: Mining activities have continued to fall, with investment in the sector declining from its peak of 9.0 percent of GDP in 2012–13 to 4.5 percent in 2015–16.2 According to a Deloitte Access Economics report, the steepest fall in this sector’s business investment is likely to happen over the next 18 months, which implies that Australia has to look elsewhere for growth.3 However, despite a strong pick-up, investment in the nonmining sector has only partly offset the lacunae created by falling mining investment. Recent monthly data, such as the industrial production index and performance management index (PMI), indicate a soft patch in the industrial and manufacturing sector. Australia’s PMI has been swaying close to contractionary territory (below 50) in the past three months, which does not bode well for the economy as it tries to transition away from mining.4

“Lowflation” a concern: Australia’s inflation peaked almost a decade ago, and prices have been steadily falling since. Low inflation has hurt corporate profitability and, thereby, business investment. Several factors such as restrained wage growth, heightened competition in product markets, and the depreciation in China’s domestic currency have contributed to low inflation. Moreover, inflation expectations have been falling, which may be influencing price- and wage-setting behavior.

Stagnant wages: In Australia, wages are the single largest component of the national income, and annual wage growth slipped to record-low levels in October 2016. Falling workforce participation and underemployment are resulting in slowing wage growth. While the unemployment and job creation rates have been steady, the trend in job growth has been firmly toward part time rather than full time. This has limited wage growth in several sectors of the economy. With aging demographics, it is expected that the downward pressure on wages is likely to stay. Stagnant wages have weighed on household spending and will likely restrain national income growth.

Noncommodity trade: Commodities are the biggest export component, and a third of Australia’s exports go to China. Consequently, the economy has been highly vulnerable to commodity price fluctuations (and thereby terms of trade) as well as to China’s economic activity. For instance, exports in Australia picked up in 2016 because of increasing iron ore prices and rising demand for iron ore as construction in China revived. However, risks associated with both these factors are higher in the medium term, and the Australian economy continues to feel the adverse impact of excessive dependence on commodity exports to China. Lately, Australia has improved services exports from its southeast region and is diversifying the country's trade basket. However, services still account for less than a quarter of total exports.

Excess easing of monetary policy: The RBA has done a remarkable job of supporting growth, especially during the years of the global financial crisis. Prudent monetary policies are partly the reason why Australia has not experienced a recession since the 1990s. The RBA steadily decreased the cash rate (policy interest rate) over the years to offer support to the Australian economy. However, at the same time, low credit costs have been pumping up household leverages and real estate prices, which are already 22.0 percent overvalued per Deloitte estimates.5 Lower interest rates have resulted in excess construction of houses, which are then sold to households that are struggling to finance these purchases.

External challenges have not lessened

Exports (of liquefied natural gas and iron ore), which have buttressed growth lately, face risks from weaker growth and rising trade protectionism among Australia’s major trading partners. Specifically, increasing uncertainties due to the Brexit referendum and US elections, and high liquidity due to several advanced nations’ unconventional monetary policies may have severe trade implications for Australia in the long term.6

Clearly, policies with respect to trade, climate, and foreign relations and investments will likely change in the United States and the United Kingdom and will impact the global economy. This offers China an opportunity to accelerate its effort to pursue new trade relations in the Asia-Pacific region. Amid growing concerns that the US-led Trans-Pacific Partnership agreement will definitely not be implemented with Donald Trump’s election, Australia may benefit from China’s increasing presence in trade in the region. According to Deloitte Access Economics, trade-related developments and geopolitical uncertainties may be net negative for Australia. However, the pace of these and their impact are expected to be slower and smaller.7

Finally, increasing global liquidity has resulted in a steady appreciation of the Australian dollar. Australia has been mostly a bystander in global currency wars, which has resulted in an overvaluation of the domestic currency, impacting export competitiveness and revenues. With rising trade protection among trading nations, Australia’s exchange rate may suffer further.

The risks indicate that Australia might, perhaps, fall shy of the federal government’s forecast over the next few years. The government might have to concentrate on longer-term plans, especially in propping up nonmining sector investment and trade, to ensure sustainable growth.