Australia's Great Rebalancing Act - Looking Beyond The Mining Investment Boom

Macro Economics Australia November 2012
Australias great rebalancing act

Looking beyond the mining investment boom
Australias growth has been uneven in recent years, as the economy has absorbed a massive mining investment boom With mining investment expected to peak in mid-2013, some rebalancing of growth is needed We expect lower RBA rates and a steady AUD to spur a recovery in the housing, retail and tourism sectors in 2013, helping maintain solid growth
By Paul Bloxham
Disclosures and Disclaimer This report must be read with the disclosures and analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it
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Key points
Two major forces have affected Australias economy in recent years. High global commodity prices have driven a massive mining boom, supporting growth, while at the same time households have increased saving, which has been a drag on growth. But Australia has been lucky. The net result of these opposing forces was around trend growth, close to full employment and low inflation. Growth has been uneven across sectors, with a strong mining sector and weaker conditions elsewhere, but the overall story has been positive. Now that commodity prices have peaked and the mining investment peak is also in sight expected around mid-2013 the true test is coming. Can Australia see growth rebalance away from mining and towards other sectors? Or, does Australia have a resources curse that has hollowed out its economy and will constrain its ability to continue to grow? Last year we wrote a report tackling this question and concluded that while not everyone would benefit from the mining boom, the overall economy is expected to be significantly better off than otherwise (see Does Australia have a resources curse?, 18 August 2011). We retain this view. Australias economy has absorbed a once-in-a-generation mining boom successfully, with few signs of irrational exuberance and inflation remaining low. The high AUD and above average interest rates in 2011 held back some sectors to make way for the mining expansion. Looking ahead, we expect recent cuts in interest rates to below average levels to drive a rise in housing construction and house prices, which should also support retail sales. Gradual recoveries are also expected in a number of the sectors that have been held back by the high AUD, including tourism, as the effect of the high AUD on growth wears off and Asian incomes continue to rise. Given that mining investment is still expected to rise until around mid-2013, there is time for these other sectors to gradually recover. We remain optimistic that Australia will see a smooth rebalancing of growth for a number of reasons. First, Australias financial system is in good shape, so monetary policy still works. Second, previous financial imbalances are well on the way to correcting. Households have increased saving and paid down debt ahead of schedule for a number of years and local banks have been shifting away from reliance on foreign wholesale funds towards domestic deposits. Lastly, government debt is low and Australia does not have sovereign debt problems. Critically, our positive outlook relies on ongoing growth in Asia, supporting commodity prices and furnishing Australia with other opportunities. As the Asian middle classes expand and spending patterns shift, demand for education, tourism and other services will grow. The benefits Australia could reap from the Asian Century should extend well beyond the mining sector.
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Contents
Key points Mining story not over yet
Mining has been the big story Not over yet Mining story has three stages Foreign involvement a cushion Growth has been uneven due to mining But not that uneven High household saving also driving unevenness
1 3
3 4 4 8 8 9 9
Resources curse revisited

Has Australia been cursed? If its permanent, its all okay High commodities = high AUD? The curse of weak productivity growth A sharper global slowdown
19
20 20 20 21 25
Other risks
A weaker monetary transmission mechanism Australias fiscal cliff A stickier AUD
25
26 27 27 28
The great rebalancing act

Shift back needed Housing ripe for recovery, though slow take-off so far Retail sector should improve Businesses have lowered debt levels AUD effect should wear off
11
11 12 14 15 16
Rebalancing smoothly the key challenge
Forecast table Disclosure appendix Disclaimer
29 31 32
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Mining story not over yet

Rising commodity prices and rapid growth in mining investment
have supported Australian growth in recent years

Now that commodity prices have peaked, income growth is
slowing, but unless prices fall dramatically from here, the nominal economy should continue to expand
Growth in the real economy should be supported by mining into
2013 as many investment projects are yet to be completed and resource exports ramp up to support growth after this
Mining has been the big story

The re-emergence of Asia has driven a massive rise in commodity prices over the past decade. This has had a profound effect on the shape of the Australian economy. It has also been a key driver of Australias relative outperformance when compared with the rest of the developed world.
1. Commodity prices have fallen, but are still very high
recent peak in late 2011 (Chart 1). Given this massive change in global prices, Australias economy responded by shifting more of its labour and capital towards the production of industrial commodities. Now that commodity prices have peaked though, concerns that Australia could see a mining bust, following its mining boom, have become more commonplace. We think these concerns are largely unfounded for a number of reasons. These include: our house view that Chinas growth will pick up next year; that we expect commodity prices to stay structurally high; that there is still a significant amount of mining investment yet to be completed on projects that have already started; and that we are yet to see a significant ramp up in resource exports as a result of the capacity that is being built. While the contribution of the mining sector to growth will probably be less in the future than it has been in the recent past, the mining story is not over yet. Plus, below average interest rates and a
Paul Bloxham Chief Economist, Australia and New Zealand HSBC Bank Australia Limited +61 (2) 9255 2635 paulbloxham@hsbc.com.au
Australia's Commodity Prices

2008/09 = 100
Index In USD 160 120 80 40 0 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012
Source: RBA
Index 160 120 80 40 0
In AUD
Commodity prices quadrupled in USD terms between the beginning of the century and their
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steady AUD are expected to result in other parts of the economy picking up and Australian growth gradually rebalancing.
2. Terms of trade to cycle around new high level
Australia's Terms of Trade

Index
F/C
Not over yet

While commodity prices have passed their peak, and we do not think they are likely to return to the very high levels reached in late 2011, they remain at high levels relative to history. Indeed, careful examination of Chart 1 reveals that, while commodity prices have fallen over the past year (by around 20%) they remain above the high levels reached at their previous peak in 2008 in USD terms (which was much celebrated as a very high level of commodity prices at the time). We expect commodity prices to stay well above the very low levels they reached in the 1980s and 1990s. We covered this topic in greater detail in a recent report: Commodities and the global economy: Are the current high prices the new normal?, 8 August 2012. In short, we argued that back in the 1980s and 1990s, when commodity prices were very low, global growth was being driven by the developed world and its very large services sectors. Now that the emerging economies are driving global growth and have large infrastructure requirements, we expect commodity prices to remain at high levels. Put simply, global growth is now more commodityintensive than it was in the 1980s and 1990s. While Australias terms of trade the ratio of export prices to import prices have fallen recently, in line with the slowdown in China, we expect they will start to level out soon, after declining by about 15% from their peak (Chart 2). At this level they would still be around 70% above their level in 2000 (which is around their long-run average level).
100
80
60
40 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009 2014
Source: ABS; HSBC estimates
This is, of course, somewhat reliant on our global outlook and particularly on our forecasts for China. Our Chief China Economist estimates that Chinese growth will lift from 7.8% in 2012 to 8.6% in 2013, with infrastructure investment a key support for growth. There are already signs that Chinas economic cycle is bottoming out, which gives us some confidence that industrial commodity prices are not likely to fall too much further in the near term. Given an expected recovery in growth in China, we expect that Australias terms of trade will show a modest rise in 2013 and 2014.
Mining story has three stages

To understand the mining boom it helps to think of it occurring in three stages. First, commodity prices ramp up, then investment picks up and finally resource exports increase. We are only part way through the second stage (Chart 3). We set out this framework in July: see Downunder digest: Reports of the mining booms death greatly exaggerated, 26 July 2012.
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3. Mining boom not over yet, just part way through stage 2
Source: HSBC
First stage is over, as commodity prices have peaked

While we expect commodity prices to stay high, it is fair to say that the free kick to income growth that Australia was getting from continually rising commodity prices they rose in 9 of the past 10 years looks to be a thing of the past. Chinas growth has slowed down from the double-digit rates it maintained prior to the global financial crisis and global supply of industrial commodities is gradually increasing as we are now some seven years into the upward phase in a global resources investment cycle. Commodity prices look as though they peaked in Q3 2011. But we expect them to remain high and to cycle around levels reached in the past five years or so, in line with cycles in the economies that are at the commodity intensive stage of their development, including China.
Second stage ongoing, as mining investment still rising

While the first stage of the mining story is passed, we are only part way through the second stage. The second stage is when the high level of commodity prices motivates an increase in investment. Much investment has already begun. But given the long-term nature of a large number of the projects in the mining investment pipeline particularly the major liquefied natural gas (LNG) projects growth in the Australian economy should continue to get support from the completion of already commenced mining projects for at least the next year. The average time required from commencement of these LNG construction projects to completion is five years, and the first project only got started in 2008/09. There are seven major LNG projects in the pipeline, with the most recent only getting final approval this year (Chart 4).
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4. Massive LNG projects still under construction Estimated spend Gorgon Ichthys Wheatstone Australia Pacific LNG Queensland Curtis Island LNG Gladstone LNG Prelude
Source: Australian Treasury
6. Mining investment still to contribute to growth next year

GDP growth and mining investment
% 5 4 3 2 1
AUD USD USD AUD USD USD AUD
43.0 34.0 29.0 23.0 20.4 18.5 12.0
Year-ended change
GDP growth (y-o-y)
Work yet to be done on mining projects has only just passed its peak in H1 2012 and is at an extremely high level (Chart 5). On these estimates there is still around 30% of the value of quarterly GDP of work yet to be done. We see this as boosting the mining investment share of the economy further in H1 2013.
5. Still a lot of work yet to be done over coming years
0 -1 2000 2002
Engineering construction (contribution to y-o-y)
2004
2006
2008
2010
2012
2014
Mining Investment Pipeline*

40 35 30 25 20 15 10 5 0 1986 1989 1992 1995 1998 2001 2004 2007 2010
*Per cent of quarterly nominal GDP
40 35 30 Engineering Construction Work yet to be done* 25 20 15 10 5 0
Importantly, the contribution to growth from mining investment should be lower in 2013 than it was in 2012. Engineering construction rose by 40% in 2011, is expected to grow by 40% in 2012, but we expect it will only rise by 14% in 2013 and to fall modestly in 2014. Of course, mining investment was never going to be able to sustain its recent extraordinary pace of growth, so a slowdown at some point was inevitable. Indeed, GDP growth in Australia has been very uneven over the past year. Of the 3.1% GDP growth over the year to Q3, around half came from mining investment. Some part of this was imported, so the net domestic contribution was a bit lower than this suggests. This is, nonetheless, a large contribution from the mining sector given that it only accounts for 10% of value-added in the economy. By 2014 we expect mining investment will be a modest drag on Australian GDP growth. But, importantly, the overall mining sector is not expected to be a large drag on real GDP. As new capacity comes on line, resource exports will be boosted (the third stage), which will contribute to GDP growth.
Source: ABS
We estimate that mining investment will continue to make a positive contribution to GDP growth over the next 6-9 months, as the projects that have already commenced continue to be constructed (Chart 6). This sees the mining investment share of the Australian economy peak some time in mid-2013 at around 8% of GDP. This is very high when you consider that mining investment has averaged around 1.5% of GDP for most of the past century. In 2014 we expect the mining investment share of the economy to level out.
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Third stage yet to come, as exports still to ramp up

The third stage is when the newly built capacity becomes productive and boosts resource exports. Indeed, the massive growth in investment in recent years is yet to boost resource exports in a significant way, because much of the capacity is still under construction. Last years floods in Queensland held back coal exports until very recently, which saw an overall fall in Australias exports in 2011. As most of these coal mines have finally been pumped out we have seen a pick-up in exports in recent quarters and expect to see solid growth in export volumes in 2013 and beyond (Chart 7).
7. Export ramp up is yet to come
Industry projections suggest the medium-term outlook for growth in resource exports is strong (Chart 8). These projections are based on estimates of increased supply capacity. Coal and iron ore exports are expected to ramp up over the coming five years. The increase in LNG exports does not really pick up pace until 2014-15, when the longer-term projects come on line. With the LNG from these projects largely forward-sold on contract, the demand is fairly unaffected by changes in gas prices (for example, from competition with US shale gas production).
8. Resource export rise a medium-term growth support
Australian Commodity Exports Outlook

Mt
Financial years
Forecast Mt
600
60
Export volumes
Annual percentage change
% 8 6 4 2 0 -2 2001 2003 2005 2007 2009 2011 2013 Forecasts
300 30
0 LNG* Coal Iron ore LNG* Coal Iron ore LNG* Coal Iron ore LNG* Coal Iron ore LNG* Coal Iron ore LNG* Coal Iron ore LNG* Coal Iron ore LNG* Coal Iron ore 2016-17
2009-10
* Right hand side axis
2010-11
2011-12
2012-13
2013-14
2014-15
2015-16
Source: BREE
Exports should rise despite the global slowdown. Demand for Australias resource volumes will be supported by the fact that Australia is a low cost producer of a number of high quality resources, including iron ore, thermal and coking coal. Marginal producers are typically the first to lose market share when global demand eases. For example, for iron ore, the cost of production in China is much higher (probably around USD120 per tonne) than the Australian cost of production (closer to USD50-60 per tonne for the bulk of production). Chinese producers are likely to shut shop before Australias large producers.
As we have discussed before, Australias expansion into LNG production can be thought of as a great gift (see Downunder digest: Australias gas-fired mining boom, 3 May 2012). Technology has reduced the cost of production and allowed Australia to build capacity such that, in addition to being a large global thermal coal producer, Australias status as a global energy producer will be bolstered by a significant ramp up in LNG exports. Australia is set to become the worlds largest LNG exporter by 2017. Australia has gone from living off the sheeps back in the first half of the 20th century to being a big miner of industrial commodities and will soon further bolster its credentials as a major global energy producer.
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Foreign involvement a cushion

There has been a large amount of foreign involvement in Australias mining boom. When the mining boom was ramping up this was a source of angst, as it meant that demand was leaking offshore, and Australian domestic demand was not getting the full support from the investment ramp up. Now that the peak is in sight, and the impact of mining investment on the economy will start to fade somewhere in the forecast horizon, foreign involvement is a source of some comfort, as it has a risk sharing effect. As Australias mining sector is around 80% foreign owned, much of the volatility in income from rising and falling commodity prices is absorbed by foreign companies and shareholders, rather than the domestic economy. An eventual slowdown in mining will, of course, have an impact on local tax revenue, employment and profits, but the full force of a fall in the mining investment share of the economy, when it occurs, will not be felt locally.
9. Australia was close to full employment until very recently
Unemployment Rate
Seasonally adjusted
% 10 8 6 4 2 1978 1982 1986 1990 1994 1998 2002 2006 2010 % 10 8 6 4 2
Source: ABS
For one sector of the economy to be booming without pushing the overall economy beyond its potential, other parts of the economy needed to slow down to make way. The high AUD was a key driver of this trend (Chart 10).
10. AUD has been around 30-year highs
Exchange Rate
1.60 1.40 AUD/USD 1.20 1.00 0.80 0.60 1.20 1.00 0.80 0.60 Post-float average 0.40 0.20 1976 1982 1988 1994 2000 2006 2012 1.60 1.40
Growth has been uneven due to mining

When the mining investment boom was at full thrust, the Australian economy was operating at around full capacity. The unemployment rate has been fairly steady between 4.9% and 5.2% for most of the past two years (Chart 9).
0.40 0.20 1970

Source: RBA
The industries most sensitive to the exchange rate manufacturing, tourism, education and retail have (collectively) seen no growth in their employment over the past four years (Chart 11). To some degree, the weak growth in retail reflects other trends in household spending behaviour, though the effects of higher international competition and greater overseas travel by domestic residents have been partly due to the high AUD.
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11. Growth has been uneven across the economy
12. State divergence, though no more than average
Employment Across Industries

Index
Range of unemployment rates across states

Index
% %
Trend, February 2007 = 100

Other industries (67% of total)
110
110
2 2
105 Exchange rate sensitive industries* (33% of total) 100 2007

Source: ABS
105
1 Averages 1
100 2008 2009 2010 2011 2012
0 1978 1982 1986 1990 1994 1998 2002 2006 2010
* Includes manufacturing, retail trade, accommodation and education
Source: ABS
Disparate industry performance has also been reflected in variation in economic activity across regions. Unemployment rates were low in Western Australia the key mining state and highest in states with higher reliance on tourism and manufacturing, such as Victoria and Tasmania. Some of these trends are reversing more recently.
High household saving also driving unevenness

At the same time that Australia has seen the mining boom crowd out other sectors of the economy, there have been other forces driving structural change in the economy. Much as has occurred in other developed nations, Australian households have become more cautious in their financial choices in recent years. Growth in Australian household wealth has slowed substantially from the average rates of the first decade of the 20th century. This reflects both a slowing in house price growth and the sharp decline and only mild recovery in equity prices since the global financial crisis began (Chart 13).
13. Household wealth has been falling, but incomes rising
But not that uneven

There are signs, however, that while growth has been uneven, the degree of unevenness has not been historically unprecedented. One way to assess this is to look at the variation across unemployment rates across states. This has not been unusually large when compared with history. Indeed, the current range of unemployment rates across the country is about average (Chart 12).
Australian household wealth and income

Year-ended percentage change % 20 15 10 5 0 -5 -10 -15 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 Household disposable income Household wealth % 20 15 10 5 0 -5 -10 -15
Source: ABS; RBA
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Given declines in household wealth, Australian households have needed to lift their saving out of income to rebuild assets (Chart 14). There has also been a large reduction in households willingness to borrow.
14. Households have become more cautious
% 25
20 15 10 5 0 -5 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Household saving and debt

Per cent of household disposable income
% 200
160 120 80 40 0 -40
Debt (RHS) Saving (LHS)
Source: ABS; RBA
This has seen the household debt to income ratio level out over the past seven years. Households have been repaying debt ahead of schedule. This has been made possible because income growth has been solid in recent years, partly due to the income boost the economy got from the run-up in commodity prices.
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The great rebalancing act

As the contribution to growth from mining slows from around mid-
2013 other sectors will no longer be crowded out

Combined with lower RBA interest rates and a steady AUD this
should allow growth to gradually rebalance in 2013 and 2014

Below average interest rates are expected to support a recovery
in housing and retail, while a fairly steady AUD and rising Asian incomes should see a pick-up in tourism
Shift back needed

Households and businesses have been deleveraging. Much like the rest of the developed world, declining asset prices and reduced appetite for borrowing have seen Australias credit to GDP ratio fall (Chart 15). On its own, this would have meant much weaker growth prospects in Australia. But offsetting this drag on the Australian economy has been the runup in commodity prices which boosted the terms of trade. Rising commodity prices boosted incomes and led to a mining investment boom which supported growth while other parts of the economy, particularly those that are interest rate and exchange rate sensitive, have slowed down. Now the economy needs to see a switch back from commodity price-driven growth to creditdriven growth. This shift away from the mining industry being the key driver of growth towards other sectors of the economy is what policymakers, including the RBA, are seeking to achieve. The next couple of years are expected to see a great growth rebalancing act.
15. Need a switch from commodity to credit-driven growth

Index 240
Commodity price driven growth
Index 120
200 Terms of trade* (RHS) 160
90
60 120 Credit to GDP ratio (LHS) 80 30
40 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011
Source: ABS; RBA *Ratio of export to import prices
Source: ABS; RBA
There are a number of reasons to think they should be successful. First, the Australian banking system is in good shape and having not suffered a banking crisis, banks are well placed to lend. Banks have reported solid profits this year and nonperforming loans are low at 1.5% of total loans. Second, the parts of the economy the RBA is seeking to support are interest-rate sensitive sectors, including housing, retail and consumer services. Together these sectors constitute a much
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larger share of the Australian economy than mining. Indeed, mining is less than a tenth of value-added in the Australian economy. The bulk of the economy is services (Chart 16). Third, the RBA have time on their hands. As we noted above, the mining investment story is still supporting growth until mid-2013 which will then see the exports come on-line and support growth into 2014 and beyond. The RBA have already lowered rates by 175bp, which is starting to show some signs of supporting growth in the sectors one would expect to be supported by lower interest rates.
16. Australias economy is mostly services Share of value-added Agriculture Mining Manufacturing Utilities Construction Wholesale trade Retail trade Transport Public administration Business services - IT - Finance and insurance - Other Household services - Health - Education - Other Other
Source: ABS
mortgage rates now having decreased to below average, there are some tentative signs that the housing construction cycle has troughed.
17. Some signs of a housing construction cycle trough
Building Approvals - Australia

Number of buildings*
'000s 15 Total '000s
15
10 Houses 5 Other**
10
* Thick line represents trend numbers w hile the lighter line represents seasonally adjusted number ** Includes non-residential buldings
1995 1997
Source: ABS
1999 2001 2003 2005 2007 2009 2011
3 9 8 2 7 4 4 5 5 23 3 10 10 15 6 4 5 15
The historical relationship between the housing construction cycle and mortgage rates implies that we should expect housing construction to pick up solidly from here (Chart 18). We have in mind that housing construction will continue contribute to GDP growth in Q4 2012 and will make a solid contribution to growth in 2013.
18. Current rates setting implies construction pick-up
%
Building Approvals and Interest Rates

Cash rate, shifted 12 months (RHS, inverted scale)
bps
25
-400
Housing ripe for recovery, though slow take-off so far

Australias housing sector has been one of the key areas held back as the economy contracted to make way for the mining expansion. The key driver of this, in our view, was the above neutral interest rates the RBA kept in place through 2011, as well as the fairly hawkish rhetoric they espoused through this time. As a result, building approvals have been at very low levels. Approvals for housing construction reached their lowest level in over a decade (Chart 17). With
-25 Building approvals (year-ended change,LHS) -50 1986 1989 1992 1995 1998 2001 2004 2007 2010
400
800
Source: ABS; RBA
There are also signs that housing prices are beginning to rise, with prices up by 2.2% in the past seven months, after having fallen by 7% in the previous 18 months (Chart 19). With around 90% of Australian mortgages at variable rates, the
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below average RBA cash rate has already had a substantial impact on household income flows and this typically supports the housing market.
19. Lower interest rates are supporting a rise in house prices
20. House prices expected to rise further given lower rates

% 21
Australian housing prices and interest rates

Average mortgage rate (RHS)
% 4
14
Capital city housing prices

$'000 $'000
Mortgage rate (inverted, six months advanced, RHS)
550
550
-7 Housing prices (six month annualised growth, LHS) 2008 2009 2010 2011 2012 2013 8
500
500
-14
450
450
Source: RBA; RP-Data Rismark
400 2006 2007 2008 2009 2010 2011 2012
400
Source: RP Data
Mortgage rates are now around 100bp below average, which typically sees housing prices start to rise (Chart 20). We expect housing prices to lift modestly in 2013, with single-digit rates of growth likely. This is a forecast we first articulated in July 2012 (see Downunder digest: Australia housing outlook positive, 12 July 2012). We estimate capital city house prices rise by around 6% a year in 2013 and 2014. Given the declines in housing prices in 2011 and early 2012, some catch-up in housing prices over the next couple of years would not be unreasonable, given continued solid household income growth. Indeed, housing prices would need to rise by around 9% in each of the next two years if we are to maintain the average pace of house price growth that has been apparent since the end of Australias 2002-03 house price boom. That is, for housing price growth to average 4% over the five years to end-2014 which is its recent average pace and broadly in line with household income growth housing prices would need to rise by 9% a year for the next two years, given the price falls in 2011-12.
Housing loan approvals have already started to pick up in response to below average mortgage rates, though the recovery is, so far, more mild than during previous upswings (Chart 21). We expect below average mortgages rates and rising housing prices to start to see a further pick-up in new housing credit in 2013.
21. Housing loan approvals slow to start, but are rising
$b 20
Housing loan approvals and mortgage rates
% 4
18
Housing loan approvals (LHS)
Mortgage rates (RHS)
16 7 14
12
2005
2006
2007
2008
2009
2010
2011
2012
Source: ABS
A shortage of housing in Australia is another reason to expect a further pick-up in housing construction and is expected to continue to be a key support for housing prices. Given the low rates of housing construction, most estimates suggest Australia still has a housing undersupply relative to the rates of population growth. This is reflected in low rental vacancy rates (Chart 22). Rents are also rising in the major
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capital cities, which is another sign that there is undersupply relative to demand.
22. Low rental vacancy rate implies undersupply continues
% 6 5 4 3 2 1 0 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010
23. Household consumption solid, but retail spending weak

% 10 Consumption
% 6 5 4 3 2 1 0
Retail Sales and Consumption

Year-ended growth, nominal
% 10 8 6 4 2
National rental vacancy rate
8 6 4 2 Retail sales 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Source: ABS
Source: REIA
Retail sector should improve

The retail sector has been weak in recent years. Demand for goods has been subdued in part because household wealth has declined. To rebuild lost wealth, households have been saving more out of their income and have been spending less on goods. What is interesting, however, is that while retail spending has been weak, overall household consumption spending is growing at about its average pace (Chart 23). Households have been spending more on services, on-line purchases and on international travel than previously. With solid income growth, households have had solid overall consumption growth and still maintained elevated rates of household saving.
The retail sector has also been put under pressure by the high AUD. It has encouraged increased international travel by domestic residents, and thus more spending abroad. The high AUD has also seen greater on-line purchases from offshore providers. In addition, the high AUD has put downward pressure on imported goods prices, eroding local retailer profit margins. But there are a number of reasons retailers should be optimistic about the future. First, Australian households have done a fair bit of deleveraging already, having done most of the heavy lifting of their saving rate 3-5 years ago. The household saving rate rose by 9.4 percentage points between 2007 and 2009. It has only risen by 1.2 percentage points in the past three years. Most households are also now well ahead on their mortgage repayments. Second, the RBA has lowered rates by 175bp and is looking to provide support for the retail sector as they seek to rebalance Australian GDP growth when the mining investment contribution to growth fades later next year. Third, lower rates are already driving some recovery in housing prices and the residential construction cycle. As more houses are built, more furnishing and durables will be purchased to fill them.
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Fourth, the depressing effect of the AUD on growth in retail sales and on retail margins should start to wane, as the currency has now been steady at above USD parity for over two years. There has already been a significant slowdown in growth of international travel by Australian residents (which implies that the drag on growth is less than it has been previously). With lower growth in international departures there is likely to be less of a pick-up in spending abroad by Australian residents. There has also been strong growth in international arrivals from China over the past couple of years, with this trend set to continue. The depressing effect of the previous AUD appreciation on imported goods prices is starting to wear off which should see local retailers better able to maintain margins (discussed below).
24. Consumer sentiment is showing improvement
the local and global economies and above neutral interest rate settings in 2011 held them back. Surveys have suggested that conditions in the business sector as a whole have been slightly below average recently (Chart 25). This is significantly weaker than the heady days of the mid-2000s. This partly reflects that growth has been very uneven. Without direct exposure to the mining sector many corporations have been struggling. Business surveys had shown significant weakness in the retail, manufacturing, construction and business services sectors. There has, however, been some recent improvement in reported conditions in the retail and manufacturing industries, consistent with the notion that the negative effect of the high AUD on these industries is starting to wear off. Construction remains very weak up to Q3 2012 though we expect a recovery soon.
25. Business conditions have dipped a little below average
Consumer Survey Questions

125
Long run average = 100
125
100
100
30
Business Conditions
30 20 10 0 -10 -20 -30 -40 -50
75 Good time to buy a household item 50 2000 2002 2004 2006 2008
Consumer sentiment
20
75
10 0
50 2010 2012
-10 -20 -30 -40
Source: Datastream; Westpac-Melbourne Institute
There are some early signs that suggest demand for retail goods and services is improving. Consumer sentiment has improved recently, which is perhaps a precursor to improvement in the retail sector (Chart 24).
-50 1989 1992 1995 1998 2001 2004 2007 2010
Source: Datastream; National Australia Bank
Businesses have lowered debt levels

Much of the Australian corporate sector, outside of mining, has been under pressure in recent years as the high AUD, rapidly changing structure of
Weaker conditions in the non-mining corporate sector have been reflected in falls in business credit, until recently (Chart 26). Miners were doing the bulk of the investment and were cashed up due to rising commodity prices, which has been supporting business investment growth even though but credit growth had been weak. The
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businesses doing the investment did not need to borrow from local banks.
26. Business credit growth has started to pick up
% 6
Year-ended (RHS)
(Chart 28). Keep in mind that we see the mining investment share of the economy still increasing until the middle of next year.
28. Forward-looking surveys show falling non-mining capex
Business credit growth
% 30
Capital Expenditure Survey

Current prices
$bn 125 100 $bn 125 100 75 Non-Mining 50 25 Mining 0 1989
Source: ABS
4 2
20 10
0
Monthly (LHS)
0 75 -10
-2
50 25 0 1993 1997 2001 2005 2009 2013
-4 2000
Source: RBA
-20 2002 2004 2006 2008 2010 2012
Source: RBA
The positive aspect here is that falling credit has meant that the corporate sector has been deleveraging. Australian listed company gearing rates are at very low levels relative to history (Chart 27). Across the distribution of corporations it is clear that the most highly leveraged have been the ones that have done the most deleveraging. Overall, the corporate sector looks well placed to expand.
27. Corporate gearing is low, so well placed to rise
AUD effect should wear off

One of the key constraints to a pick-up in the economy has been the strong AUD. Clearly some industries would be quite happy if the AUD were to depreciate somewhat from its current level. It is worth keeping in mind, however, that the AUD has now been steady for more than two years, at an average of just over parity against the USD (1.03). Without appreciating further we expect that the drag the AUD has had on growth in various sectors of the economy will start to wear off. While it has had a dampening effect on some sectors and has been a key catalyst of the structural change in the economy, we expect that the effect on growth will not be permanent. Indeed, there are some early signs that the depressing effect of the AUD appreciation on growth is already starting to wane, particularly in the tourism industry.
Source: RBA
At this stage, surveys of investment intentions show no expected growth in non-mining investment in 2013. While this is somewhat disconcerting, there is still time for a pick-up in intentions to materialise
Tourism
One way the AUD has had its impact of dampening some sectors of the Australian economy has been by making it more attractive
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for Australian residents to travel abroad. While abroad, Australians spend not just on travel and hotels, but also on retail goods. This has seen significant demand leakage, which has had a tangible impact on the Australian local tourism industry and the retail industry. While estimates of the size of the tourism industry are not made as a regular part of the quarterly national accounts framework, there are special accounts calculated infrequently suggesting that consumption by tourists probably accounts for around 7% of the value of GDP and employs around 500,000 people. In 2011 the net flow of tourists into Australia (overseas arrivals less domestic departures) was 1.8 million people. This compared with a net flow of 1.2 million in 2010. Between those two years there was a very large swing. If we assume that the average tourist spends AUD3,000 on a twoweek holiday on retail sales as the statistics bureaus survey suggests this amounts to AUD1.8 billion, which is around 0.7% of retail sales. That is, the AUD appreciation and swing in tourist numbers had a noticeable dampening effect on local retail sales. More recently, however, we have seen a significant slowdown in growth in international departures. This has come despite the AUD remaining high. This is what you would expect to happen, as the AUD has not continued to appreciate it has not continued to provide increasing incentive for more international travel. The biggest impact of the AUD on tourism and associated spending occurred when the AUD appreciated in 2009. In that year, the 25% AUD appreciation saw 15% growth in international departures of Australian residents. Over the past year, these departures have only grown by 4% (Chart 29). So while the increase in the net flow of tourists in 2011 was a massive 600,000 people, it is only expected to be 150,000 people in 2012.
29. Biggest negative AUD effect on tourism is in the past

% 25 20 15 10 5 0 -5 2005 2006 2007 2008 2009 2010 2011 2012
Overseas departures (LHS)
Overseas departures and the exchange rate

Year-ended percentage change
% 30 20 10 0 -10 -20 -30
AUD trade-weighted index (RHS)
Source: ABS; RBA
The effect of the AUD on arrivals from offshore should also diminish, particularly on arrivals from Asia, as their incomes rise every year which is boosting purchasing power over Australian recreational activities, even without AUD depreciation. Increased demand for recreation by Asian consumers is already having an effect on the Australian tourism industry. In the past two years the number of short-term visitors to Australia from China has risen from 1.4 million to 2.1 million. Growth in Chinese visits to Australia is by far the strongest amongst the range of countries in that period (Chart 30). This trend is set to continue. HSBC estimates that 60 million people left mainland China to visit other parts of the world in 2011 and expects this to rise to 130 million by 2015. If Australia only gets a constant share of that increase, then the Chinese will be the most prolific visitors to Australia in three years time (second only to New Zealand).
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30. Already big shift in source of overseas arrivals, to China

Overseas Arrivals*
200 180 160 140 120 100 Asia ex China (32%) 80 2007 2008 2009 2010
*Share of total in July 2012 in brackets
Index January 2007 = 100
China (11%)
Other (12%) US (7%) NZ (20%)
Europe (18%) 2011 2012
Source: ABS
Manufacturing
Manufacturers in Australia have been very vocal about the impact of the exchange rate. This is understandable, as it directly affects their competitiveness. However, the extent of weakness needs to be assessed keeping in mind that there has been a secular downward trend in the manufacturing industry in Australia since the mid-1950s as has been the case in many developed world economies. The downward trend in manufacturing in the West has been mostly driven by global wage differentials rather than currencies per se. Indeed, despite the high level of the Australian dollar, manufactured exports have continued to rise in recent years (Chart 31).
31. Manufactured exports have continued to rise despite AUD
There has, however, been a faster than usual fall in employment in the manufacturing industry in the past couple of years. This probably reflects the impact of the currency, through a number of different channels. First, the high AUD makes Australian manufacturing less competitive in price terms, which means local manufacturers profits have been under pressure, forcing them to reduce costs. Second, the high AUD encourages local manufacturers to shift their operations offshore, as the strong AUD lowers the cost of production elsewhere in local currency terms. Third, the high AUD puts downward pressure on the prices of imported capital goods encouraging firms to substitute capital for labour. All of these effects are strongest when the currency is appreciating. The effect of these forces on local growth should start to reduce as firms have spent the past two years making adjustments in the face of the high AUD. In this way we do not expect the high AUD to be a persistent drag on growth in the manufacturing industry.
Education exports
One area of the Australian economy that has been weak recently, but has medium-term prospects is education exports. Expanding middle classes will drive increased demand for education. Being a developed economy with geographic proximity to Asia should help Australia to take advantage of demand for education services. While education exports have been hampered in recent years by the strong AUD and student visa cutbacks, this area should remain a medium-term focus for policymakers, as it will offer opportunities to Australia in the future. But there are clearly risks to this outlook. These are covered in the next two sections.
Manufacturing indicators
Index Q1 1990 = 100 105 Exports (RHS) 100
3.9% 2.9%
600 500 400 300 200 Employment (LHS) 100 1993 1996 1999 2002 2005 2008 2011
95 90 85 80 1990
Source: ABS
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Resources curse revisited

A much discussed risk is that Australia could have a resources
curse or so called Dutch disease which could constrain its ability to rebalance smoothly
As mining gradually fades, other sectors need to recover to
support growth, which may not happen smoothly if Australia has these resource curses
We remain unconcerned about Dutch disease, as we wrote last
year, but are worried about Australias recent weak productivity performance, which is another of the resource curses
Last year we posed the question: Does Australia have a resources curse? (see our report dated 18 August 2011). As we explained back then, the resources curse comes about when the gift of higher commodity prices leads to other problems in the economy. This can take a number of forms. The one most frequently discussed in relation to Australia is Dutch disease. Dutch disease describes the situation where a resource discovery leads to a significant capital inflow that forces an exchange rate appreciation, making other sectors of the economy less competitive and thus hollowing out the economy. This is referred to as Dutch disease because of the Netherlands experience in the late 1960s with discovery of natural gas that led to an apparent hollowing out of the economy and shrinking of the manufacturing industry, as a result of the strong appreciation of the local currency.
Interestingly though, as we noted last year, the Dutch did not really have Dutch disease. Once the resource boom was over, the manufacturing industry recovered. This happened despite the guilder staying at high levels. We also noted last year, that Dutch disease only occurs if permanent damage is done, such that the economy is worse off in the medium term, for having had the mining boom. So while it is possible to argue that Australia has had weakness in the exchange-rate sensitive industries, to argue that it has Dutch disease is to suggest the economy is permanently worse off for having the run-up in commodity prices and the high AUD. We do not think this is the case. Another curse we discussed last year was that of a stymied reform agenda. This comes about because the free kick from rising commodity prices boosts incomes such that policymakers and businesses lack impetus to reform and improve
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the efficiency of the economy, leaving the economy with weak productivity growth.
take full advantage of a permanent change in the composition of global demand. We have recently argued that commodity prices are, indeed, likely to stay around current levels and well above the levels reached in the 1980s and 1990s (Commodity and the global economy: Are current high prices the new normal?, 8 August 2012). In our view, this reflects that the composition of global growth was unusual in the 1980s and 1990s in that it was driven by already developed economies with large services sectors, which could grow without the need for commodities as an input. With the bulk of global growth now coming from the emerging world which needs large amounts of commodities in order to build infrastructure and make consumer durables commodity demand is expected to stay high, which is expected to maintain structurally high commodity prices.
Has Australia been cursed?

Last year we concluded that while not everyone would benefit from the mining boom, the overall economy is expected to be significantly better off than otherwise, so we do not think that Australia has Dutch disease. We remain of this view. While it has been true that some sectors of the economy have been under a great deal of pressure from the high AUD, we view this as necessary structural change, rather than something that will permanently lower Australias growth potential. As the commodity price rise that occurred over the past decade was driven by global forces, there was little Australian policymakers, businesses or households could do except to make adjustments to the economy to best take advantage of the change. The key development has been the mining investment boom as Australia invested in capacity to meet international demand for commodities.
If its permanent, its all okay

Now that commodity prices have peaked, the question is whether the structural change in the Australian economy will leave it with less productive capacity overall? Much of this depends on whether the change in commodity prices to much higher levels than in the 1980s and 1990s is permanent. If not, and they were to fall back to the levels of the 1980s and 1990s, then Australias economy would face some challenging times as the economy has recently been shifting in structure to meet high demand for commodities. But if commodity prices do remain at around their current levels, rather than falling back to the levels of the 1980s and 1990s, as we think they will, then the shift in Australias productive capacity towards mining should be thought of as an adjustment to a
High commodities = high AUD?

As Australia is a large commodity producer, its currency has followed broad trends in commodity prices. Structurally high commodity prices may also mean a structurally higher AUD. A long-run comparison of the AUD and commodity prices shows a striking resemblance (Charts 32 and 33). What is most interesting is that both the AUD and global commodity prices were at very low levels in the 1980s and 1990s. Indeed, the last two decades of the 20th century appear to be the unusual periods in both the history of the AUD and real commodity prices, when both were at very low levels compared with history.
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32. Has the currency really been that high, or is it back to a more normal long-run historical level?
3.00 2.50 2.00 1.50 1.00 0.50

UK pound per AUD
Nominal Exchange Rate

Float USD per AUD
3.00 2.50 2.00 1.50 1.00 0.50 0.00
0.00 1901 1908 1916 1923 1931 1938 1946 1953 1961 1968 1976 1983 1991 1998 2006
Source: RBA
Despite having risen for the most of the past decade, commodity prices have only gotten back to the sorts of levels they were at on average over most of the past 150 years. Likewise the AUD is back to the sorts of levels it maintained for most of the post-War period.
The curse of weak productivity growth

While we do not think Australia has Dutch disease we do think that recent weak productivity
growth may at least be partly due to another resources curse: the curse of a lack of impetus for reform. Specifically, the free kick to income growth from almost continually rising commodity prices over the past decade has left policymakers and businesses with less incentive to adopt productivity enhancing measures. Indeed, weak productivity growth is one of Australias greatest challenges. Over the past six years labour productivity has averaged 1.2% a
33. Despite the run-up in commodity prices in the past decade, they are only now back to around real long-run average levels
Real Commodity* Price Trends

Average for 1860-2010=100
Index Index
110
110
100
100
90
90
80 1865
* Excludes oil
Source: Erten and OCampo (2012)
80 1875 1885 1895 1905 1915 1925 1935 1945 1955 1965 1975 1985 1995 2005
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year, which is a significant slowdown from productivity growth of around 2% a year in the prior five years (Chart 34). However, assessing why productivity growth has slowed is not straightforward. There are two main competing arguments. One suggests that the weakness is structural and could reflect a lack of reform (a resources curse). The other suggests that it could largely reflect the unusual composition of growth in the Australian economy and the structural change that is occurring, particularly developments in the mining and utilities industries.
34. Productivity growth has been weak
Is it just part of the structural change?

On the other hand, a number of analysts make the argument that the unusual recent composition of Australian growth explains the weakness in productivity growth. The composition of growth argument suggests that weakness in productivity growth in the mining and utilities industries, for special reasons specific to those industries, explains the productivity growth slowdown (Chart 35). For mining the argument is that much of the recent growth has been driven by investment which is yet to boost measured output because the projects are medium term big developments, with the boost to resources exports not occurring until the projects are completed. The seven major LNG projects being built in Australia are examples of this as none of them has yet produced any LNG but much capital and labour has already gone into their construction. With little output (resource volumes) but lots of input (capital and labour), measured productivity growth in the mining industry has been weak.
35. Decomposition of trend productivity growth ______________ Annual percentage change _______________ 1973/741993/942003/041993/94 2003/04 2010/11 Selected market sector industries Labour productivity 1.8 3.1 of which: Capital deepening 1.3 1.3 Multifactor 0.6 1.8 productivity Excluding mining and utilities Labour productivity 3.1 of which: Capital deepening 1.3 1.9 Multifactor productivity
Source: RBA
GDP per hour worked*

Index (log scale)
5.20 5.10 5.00 4.90 4.80 4.70
190 2000-05 1.9%pa 1990-95 1.7%pa 1980-85 1.6%pa 1985-90 0.9%pa 1995-00 2.6%pa 2005-11 1.2% pa
130
110
100 4.60
1980
Source: ABS
1984
1988
1992
1996
2000
2004
2008
2012
Is it the curse of lack of reform?

Possible drivers of weak productivity growth include: limited reform of the tax system; a labour market that is no more flexible than it was five years ago; and, increased regulation across the economy. Businesses have also played a role. The free kick from the rise in commodity prices means there has been less incentive for firms to adopt efficiency enhancing practices in recent years.
1.4 1.8 -0.4 1.7 1.3 0.4
There are similar developments in the utilities sector. Much of the recent investment has been in electricity capacity to meet peak demand. Indeed, estimates suggest that around 25% of the local electricity generation capacity exists to produce around 4% of the output. For example, much of
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the capacity is there to ensure supply when the bulk of households all turn on their air conditioners at the same time. There has also been significant investment in recent years to ensure consistent supply of water, in some cases using desalination plants. These two industries alone account for around half of the slowdown in productivity growth in recent years on most estimates. But this is not the full story.
36. Underlying inflation may have passed its trough
Measures of Underlying Inflation

% 5 4 3 2 Trimmed mean 1 0 CPI (excl vol items) 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Source: ABS; RBA
Year-ended change
% 5 4 3 2 1 0
Weighted median
The verdict is that overall productivity is still weak

Coming to a conclusion about which is the more important explanation for the weak productivity performance is difficult to do in real time. It seems likely that the industry-specific mining and utilities issues are important, but given the broader slowdown in productivity growth there are probably other factors at play, such as the weakened reform agenda.
Domestically produced inflation non-tradeables has been running above the RBAs target band in recent years (Chart 37). Overall inflation has only declined because of the lagged effect of the appreciation of the AUD in 2009-10, which has caused imported goods prices fall, driving down tradeables inflation.
37. AUD effect wearing off and domestic inflation solid
What weak productivity growth means

One of the key implications of weak productivity growth is that the Australian economy may not be able to grow as quickly as it has in the past. If that is the case, then inflationary pressures will build at lower rates of GDP growth than in the past and the unemployment rate may not be able to be sustained at the low levels it reached prior to the global financial crisis (in the 4s) without stoking inflation. There are already some early signs that weak productivity growth may have implications for inflation. Underlying inflation appears to have already passed its trough, having risen from the bottom of the RBAs target band to around the middle in Q3 2012 (Chart 36).
% 6 4 2 0 -2 -4
Components of Inflation
Year-ended change
Non-tradeables (domestic) % 6 4 2 0 Tradeables (mostly imported) 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Source: ABS; RBA
-2 -4
High domestically produced inflation reflects weak productivity growth, in part because wages growth has been too rapid given the pace of productivity growth. As the effect of the previous appreciation of the AUD is already wearing off, maintaining low inflation will require a fall in non-tradeables inflation. But the weakness in productivity growth and comparatively high level
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of non-tradeables inflation are related. If productivity growth is structurally weaker than it used to be, then Australias sustainable growth rate is also lower than if used to be and growth will need to slow down to get a further disinflationary pulse into the system. The simple arithmetic used to be that inflation could be sustained at 2.5% a year if wages grew at 4% and productivity growth was 1.5%. But if productivity only grows at 1% a year, the sustainable pace of wages growth is closer to 3.5%. Thankfully, there are some signs that wages growth has slowed in the past quarter (Chart 38). There are also some signs that productivity growth is lifting, although it is too early to be confident that this issue has been resolved.
38. Wages growth has slowed in the past quarter
Our own estimates suggest that if productivity is not lifted, then the sustainable pace of growth in the Australian economy could be around 2.502.75%, rather than the 3.00-3.25% growth that Australia could previously sustain (see Downunder digest: Australias productivity challenge, 29 February 2012). If productivity growth does not lift much further, then the sustainable unemployment rate may also be closer to 5.25-5.50%, rather than the 4.75-5.00% previously achievable. Lower structural rates of productivity growth could also constrain the RBAs ability to cut rates further to support growth. The RBA is only able to affect demand and has almost no effect on the supply side of the economy (that is, on productivity).
Labour Price Index Growth

Seasonally adjusted
%
4
% 4 Year-ended 3 Six month annualised Quarterly 2 1 0 1999 2001 2003 2005 2007 2009 2011
3 2 1 0
Source: ABS
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Other risks
A sharper global slowdown remains a key risk, particularly if China
and commodity prices weaken further

Another risk is that monetary policy could be less powerful than
before, given households more cautious behaviour, or that political constraints could force tighter than ideal fiscal policy
Recent stickiness of the local currency could reduce the ability of
the AUD to absorb global shocks
A sharper global slowdown

The biggest risk Australia faces is a slowdown in global growth. This would be most problematic if we saw a further slowdown in China and another large decline in commodity prices. This year the European financial crisis had a larger impact on global trade than had been expected and Chinas economy slowed more than initially expected. Europe is Chinas major trading partner and while Australias direct exposure to Europe is small, its indirect exposure through Asias trade is large. The effect of the slowdown in China also flowed through to Australia via lower commodity prices. The banking and fiscal problems in the euro area are far from resolved and remain a key risk to the global outlook. While ECB support and the promise to do whatever it takes to keep the euro together have stabilised conditions recently, there are many reforms that need to be made before there is confidence that the euro area economy is on a sound footing. We expect the euro area economy to continue to contract modestly into 2013, which will be a headwind for global growth. The risk of
another financial meltdown is still significant. The US also faces enormous fiscal challenges that threaten global growth prospects. Far and away the greater risk for Australia is the possibility of weaker growth in China and what that could mean for commodity prices. Of course, Chinas performance is related to the West through significant trade and financial linkages. As 2012 has demonstrated, a shock from the West can still have a distinct effect on the Rest. Australias GDP growth has become more correlated with that of China (Chart 39). This reflects that around 30% of Australias exports go to China. This also reflects that China is Australias key commodity export market and that commodity prices have become a bigger driver of Australias cycle in recent years.
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39. Australias economy now highly reliant on China
Real GDP Growth in China and Australia

%
Year-ended change
China (LHS)
12
equilibrium. While saving is still only at 10%, rather than the 15% rate it averaged in the 1960s, 1970s and 1980s, households have additional saving now in the form of superannuation, which is not included in the household saving rate measure. This implies that we should expect to see the saving rate settle at a lower level than it did in the 1960s and 1970s. Third, the banking system still works in Australia and credit is available. Unlike many other developed economies, credit supply has not been constrained by a banking crisis and subsequent bank balance sheet repair.
40. Bulk of household saving rise may already be done
4 Australia (RHS) 0 1996 1998 2000 2002 2004 2006 2008 2010 2012
Source: Datastream
A weaker monetary transmission mechanism

Our base line forecasts assume that monetary policy is still powerful in Australia. However, there is some risk that monetary policys power has been reduced by ongoing household deleveraging. In this way, a factor that could mitigate the impact of lower interest rates in supporting growth may be increased household caution, which could see reduced willingness to borrow and spend. Instead, households may choose to pay down debt. With the household saving rate still below the level it averaged in the 1960s, 1970s and early 1980s, it is possible that the saving rate could continue to rise further in coming years, back to those previous levels as households seek to rebuild lost wealth (Chart 40). There are, however, some reasons to think that this will not happen. First, the pace of increase in the household saving rate has slowed down substantially in the past couple of years, after having ramped up 3-5 years ago after the global financial crisis drove a sharp fall in household wealth. Second, there are reasons to think that the current level of the saving rate may be close to a new
Household Saving
%
20 15 10 5 0 -5 -10 -15 -20 -25 1963 1968 1973 1978 1983 1988 1993 1998 2003 2008 2013
*Three-year rolling change
Level of saving rate
40.0 35.0 30.0 25.0 20.0 15.0 %
Change in saving rate*
10.0 5.0 0.0 -5.0 -10.0
Source: ABS
Recent surveys of consumer sentiment provide some hope that households are becoming a bit more positive about their finances, after significantly less confidence for most of the past few years (Chart 41).
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41. Lower rates are having some effect on confidence

Personal financial position over coming year
140 130 120 110 100 90 80 70 60 2000 2002 2004 2006 2008 2010 2012 140 130 120 110 100 90 80 70 60
42. Government committed to get back to surplus this year
Federal Government Budget Balance

% 2 1 0 -1 -2 -3 -4 -5 Jun 90 Jun 93 Jun 96 Jun 99 Jun 02 Jun 05 Jun 08 Jun 11 Jun 14
Source: Federal Treasury
Budget May'12 Historical
Per cent of nominal GDP

Forecast MYEFO Oct' 12
% 2 1 0 -1 -2 -3 -4 -5
Source: Datastream
Australias fiscal cliff

The Australian government has committed to achieving a budget surplus this financial year (2012-13). To do this requires a significant contraction. The budget needs to swing from a deficit of around 3% of GDP to balance, which on a literal read would imply a contractionary fiscal impulse of 3% of GDP (Chart 42). This overstates the full effect on the economy, however, as some part of the spending cut back is on imported items, such as defence materiel. Most estimates suggest the fiscal contraction will be in the order of around 1.5-1.75% of GDP. While slower growth could see this fiscal plan adjusted, the difficulty is that the commitment made by the government has become political and is being treated as a device for establishing the governments economic credentials as we run into an election year in 2013. This makes it more likely that it will be achieved at any cost. There is therefore a risk that, even in the face of weaker economic conditions, the government may choose even more contractionary fiscal policy. This is a downside risk to the growth outlook.
A stickier AUD
The floating exchange rate has been a key part of the Australian economys armoury in recent years and helps to explain why the volatility of growth in the Australian economy has been much lower in recent years than it was in the 1970s and early 1980s. It has been a key shock absorber in the past, depreciating substantially when global conditions have weakened and appreciating in the face of positive economic shocks, such as the recent sharp rise in commodity prices. But in recent months the AUD has not been following trends in commodity prices particularly closely. Commodity prices have fallen by around 20% over the past year while the AUD has been broadly steady (Chart 43). This has put downward pressure on local income growth in local currency terms.
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43. AUD stubbornly high in the face of commodity price falls
Real Exchange Rate and Terms of Trade

150 140 130 120 110 100 90 80 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011
Source: ABS; RBA
Post-float average = 100
200 180
Real Exchange Rate on TWI-basis (LHS)
160 140 120 100 80 60
Terms of Trade (RHS)
A smooth transition from commodity price-driven growth back to credit-driven growth should be possible as monetary policy is still powerful in Australia. The bulk of RBA cash rate changes get passed on to households and businesses and fairly quickly. Plus, a larger share of the economy is interest-rate sensitive than the share that is driven by trends in commodity prices. This should see a pick-up in the housing market and retail sectors of the economy. A continued broadly steady AUD should also see some of the downward pressure on growth from of the high exchange rate start to wear off in 2013-14. While many international observers see Australia as a giant quarry, this ignores the fact that more than four-fifths of what Australia produces is services, much like the rest of the developed world economies. Our house forecast for a pick-up in growth in China from 7.8% in 2012 to 8.6% in 2013 is a critical factor supporting our view that commodity prices will stabilise and Australias economy will maintain close to trend growth. However, a key risk remains the global environment, particularly developments in the US and Europe as they continue to deal with sovereign debt problems. Other risks are domestic. The governments imperative to get back to budget surplus this year is driving a fiscal contraction that is a downside risk to Australias growth prospects, particularly if further discretionary tightening measures are required to achieve the budget surplus. The continued high level of the AUD in the face of declining commodity prices is also squeezing local income growth, which may make a smooth rebalancing more difficult to achieve.
Increased interest in holding AUD assets by foreign central banks, pension funds and sovereign wealth funds may partly explain the resilience of the currency in the face of weaker commodity prices. The triple A rating of Australian commonwealth government bonds means they are in high demand, particularly as the pool of triple A rated sovereigns has been shrinking in recent times. Foreign ownership of Australian government bonds has risen to 77%, up from 60% in late 2009. If the AUD were to stay high, even in the face of weaker conditions in the Australian economy, then the currency may lose some of its ability to absorb international shocks. This adjustment mechanism has provided the Australian economy with a great deal of protection during previous global downturns, including the Asian financial crisis and after the failure of Lehman Brothers. The sticker AUD is a downside risk to growth in the Australian economy.
Rebalancing smoothly the key challenge

We remain optimistic that the economy will be able to rebalance in 2013-14, while maintaining around trend growth.
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Forecast table
44. HSBC's forecasts for Australia Year-average 2012 2013 %* AUSTRALIA GDP Consumption Govt consumption Investment - Dwelling - Business - Public Final domestic demand Domestic demand Exports Imports GDP (% quarter sa) CPI** Trimmed mean** Unemployment rate Labour price index Current A/C (%GDP) Terms of trade Capital city house prices Private sector credit 90 day bank bill rate Cash rate (en d period) 3.5 3.5 3.5 7.7 -5.2 16.4 -6.9 4.7 4.7 5.6 6.8 -1.8 2.2 5.2 3.6 -3.8 -9.3 -0.9 4.0 3.30 3.00 2.9 2.5 0.9 6.4 5.3 10.3 -7.7 3.1 3.1 7.1 7.3 -2.8 2.8 5.2 3.6 -4.0 -1.8 5.9 6.1 3.55 3.25 3.1 2.6 2.1 4.9 9.2 2.8 9.8 3.2 3.2 6.6 7.0 -3.2 2.9 5.1 3.6 -3.4 2.6 5.9 7.5 4.30 4.00 3.1 3.3 3.5 5.3 -6.3 12.3 -7.0 3.7 4.1 4.7 3.5 0.5 2.0 2.4 5.2 3.7 -4.0 -13.6 0.3 4.0 3.50 3.50 2.8 3.3 2.3 5.0 -1.6 13.9 -17.0 3.7 3.6 3.9 4.1 0.4 2.5 2.3 5.4 3.6 -4.1 -10.0 1.9 4.1 3.30 3.00 2.4 2.2 1.1 4.1 1.4 10.6 -16.0 2.4 2.3 7.1 4.9 0.9 3.0 2.6 5.3 3.5 -4.0 -5.3 3.6 4.5 3.30 3.00 2.7 2.2 0.0 7.3 5.6 13.0 -11.9 2.6 2.9 6.7 6.8 0.8 3.1 2.7 5.2 3.5 -4.1 -4.0 5.4 5.3 3.30 3.00 3.1 2.7 0.8 6.7 7.0 9.0 -3.0 3.4 3.3 7.5 8.8 0.9 2.2 2.8 5.2 3.6 -4.0 0.4 7.1 6.7 3.30 3.00 3.5 2.9 1.5 7.4 7.4 8.7 1.9 3.9 3.8 6.9 8.8 0.8 2.7 2.9 5.2 3.6 -3.8 2.2 7.6 7.7 3.55 3.25 3.4 2.8 1.8 6.6 8.6 6.0 7.2 3.7 3.7 6.3 7.7 0.9 2.9 2.9 5.1 3.6 -3.7 2.4 7.3 8.0 3.80 3.50 2014 Q312 Q412e Q113e Year-ended Q213e Q313e Q413e Q114e
Source: HSBC forecasts
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Notes
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Disclosure appendix
Analyst Certification
The following analyst(s), economist(s), and/or strategist(s) who is(are) primarily responsible for this report, certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) and/or any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report: Paul Bloxham
Important Disclosures
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This report is dated as at 07 December 2012. All market data included in this report are dated as at close 06 December 2012, unless otherwise indicated in the report. HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its Research business. HSBC's analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBC's Investment Banking business. Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential and/or price sensitive information is handled in an appropriate manner.
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Global Economics Research Team

Global
Stephen King Global Head of Economics +44 20 7991 6700 stephen.king@hsbcib.com Karen Ward Senior Global Economist +44 20 7991 3692 karen.ward@hsbcib.com Madhur Jha +44 20 7991 6755 madhur.jha@hsbcib.com
Global Emerging Markets

Pablo Goldberg Head of Global EM Research +1 212 525 8729 pablo.a.goldberg@hsbc.com Bertrand Delgado EM Strategist +1 212 525 0745
bertrand.j.delgado@us.hsbc.com
Emerging Europe and Sub-Saharan Africa

Murat Ulgen Chief Economist, Central & Eastern Europe and sub-Saharan Africa +44 20 7991 6782 muratulgen@hsbc.com Alexander Morozov Chief Economist, Russia and CIS +7 495 783 8855 alexander.morozov@hsbc.com Artem Biryukov Economist, Russia and CIS +7 495 721 1515 artem.biryukov@hsbc.com Agata Urbanska Economist, CEE +44 20 7992 2774 Melis Metiner Economist, Turkey +90 212 376 4618
Europe & United Kingdom

Janet Henry Chief European Economist +44 20 7991 6711 janet.henry@hsbcib.com Simon Wells Chief UK Economist +44 20 7991 6718 simon.wells@hsbcib.com John Zhu +44 20 7991 2170 Germany Stefan Schilbe +49 211910 3137 France Mathilde Lemoine +33 1 4070 3266 john.zhu@hsbcib.com
agata.urbanska@hsbcib.com
stefan.schilbe@hsbc.de
melismetiner@hsbc.com.tr
mathilde.lemoine@hsbc.fr
Middle East and North Africa

Simon Williams Chief Economist +971 4 423 6925 Liz Martins Senior Economist +971 4 423 6928
North America
Kevin Logan Chief US Economist +1 212 525 3195 kevin.r.logan@us.hsbc.com Ryan Wang +1 212 525 3181 David G Watt +1 416 868 8130 ryan.wang@us.hsbc.com david.g.watt@hsbc.ca
simon.williams@hsbc.com
liz.martins@hsbc.com
Latin America
Andre Loes Chief Economist, Latin America +55 11 3371 8184 andre.a.loes@hsbc.com.br Argentina Javier Finkman Chief Economist, South America ex-Brazil +54 11 4344 8144 javier.finkman@hsbc.com.ar Ramiro D Blazquez Senior Economist +54 11 4348 5759 Jorge Morgenstern Senior Economist +54 11 4130 9229 Brazil Constantin Jancso Senior Economist +55 11 3371 8183 Mexico Sergio Martin Chief Economist +52 55 5721 2164 Claudia Navarrete Economist +52 55 5721 2422 Central America Lorena Dominguez Economist +52 55 5721 2172
Asia Pacific
Qu Hongbin Managing Director, Co-head Asian Economics Research and Chief Economist Greater China +852 2822 2025 hongbinqu@hsbc.com.hk Frederic Neumann Managing Director, Co-head Asian Economics Research +852 2822 4556 fredericneumann@hsbc.com.hk Leif Eskesen Chief Economist, India & ASEAN +65 6658 8962 leifeskesen@hsbc.com.sg Paul Bloxham Chief Economist, Australia and New Zealand +61 2925 52635 paulbloxham@hsbc.com.au Donna Kwok +852 2996 6621 Trinh Nguyen +852 2996 6975 Ronald Man +852 2996 6743 Luke Hartigan +612 9255 2635 Sun Junwei +86 10 5999 8234 Sophia Ma +86 10 5999 8232 Su Sian Lim +65 6658 8963 Izumi Devalier +852 2822 1647 donnahjkwok@hsbc.com.hk trinhdnguyen@hsbc.com.hk ronaldman@hsbc.com.hk lukehartigan@hsbc.com.au junweisun@hsbc.com.cn xiaopingma@hsbc.com.cn susianlim@hsbc.com.sg izumidevalier@hsbc.com.hk
ramiro.blazquez@hsbc.com.ar
jorge.morgenstern@hsbc.com.ar
constantin.c.jancso@hsbc.com.br
sergio.martinm@hsbc.com.mx
claudia.navarrete@hsbc.com.mx
lorena.dominguez@hsbc.com.mx
Paul Bloxham Chief Economist, Australia & New Zealand HSBC Bank Australia Limited +61 2 9255 2635 paulbloxham@hsbc.com.au Paul joined HSBC in late 2010 as Chief Economist for Australia and New Zealand. Prior to this, he spent almost 12 years working as an economist at the Reserve Bank of Australia, where he held a range of different roles in the Economic Analysis Department. These included heading up the overseas economies and financial conditions sections, and working in the domestic forecasting and prices areas. Paul has published a number of papers, including on housing and household finances, as well as on asset prices and monetary policy. Paul holds a Masters degree in public financial policy from the London School of Economics.

Australia's Great Rebalancing Act - Looking Beyond The Mining Investment Boom

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Australia's Great Rebalancing Act - Looking Beyond The Mining Investment Boom

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Macro Economics Australia November 2012