The resources boom – bigger than ever Will it be derailed by European/US events?

September 2011
Economics Kieran Davies +612 8259 5171 kieran.davies@rbs.com Felicity Emmett +612 8259 5835 felicity.emmett@rbs.com

Kieran Davies and Felicity Emmett

www.rbsm.com/strategy

Australia – The resources boom vs the sovereign debt crises
• Growth: Strong growth likely driven by the resources sector – rest of the economy underperforms • Inflation: Inflation pressures still in the system given poor productivity underpins strong unit labour cost growth • Transmission of the European/US crises: Likely channels are: (1) commodity demand, which is surprisingly resilient so far; (2) bank funding stress, which is limited compared with 2008-09; and (3) confidence, which is depressed, although it is too soon to tell whether this leads to delayed spending/hiring • Interest rates: RBA on hold given global uncertainty – history shows there is some risk of an insurance cut, but if global spillover is limited, the resources boom points to higher rates next year • Budget: All levels of Government plan to return their Budget to surplus – the Commonwealth should be first, although its target date of 2012-13 is ambitious • Politics: Minority ALP Government could face an early election, which polling suggests it would lose. Note that, the Liberal/NP Coalition would struggle to secure crucial Green support in the Senate. • Risks: (1) China – the authorities could make a policy mistake; (2) households are highly leveraged and there is a bubble in house prices – households may decide to cut gearing, but a spike in unemployment is probably needed as a trigger • Exchange rate: Averages over parity, supported by central bank buying of bonds and commodity prices

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Table of contents
World activity World inflation Market pricing of monetary policy Channels for Europe/US to affect Australia (1) Commodity demand (2) Banking linkages (3) Consumer & business confidence Dutch disease (1) Mining versus the rest (2) Manufacturing (3) Retail sales (4) Tourism 4 5 6 7 8 10 13 18 19 21 22 23 What if the world doesn’t fall apart? (1) The resources boom (2) Inflation (3) Interest rates Other key risks (1) China (2) House prices/leverage Fiscal policy Politics Exchange rate New Zealand Appendix 1 - Table of key forecasts Appendix 2 - Structure of the economy 24 25 27 33 38 39 41 43 44 45 47 48 49

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World activity – Recovery loses momentum in Q2 and Q3
• After a deep recession, the world economy grew strongly, but lost momentum in Q2, partly in response to the tragic events in Japan and higher energy prices. Business surveys point to further weak growth in Q3, with some indicators pointing to fresh a risk of recession in the US. Growth has slowed in Emerging Asia reflecting the withdrawal of policy stimulus and the impact of supply-chain disruptions from Japan, but growth remains weakest in the major advanced countries.
World real GDP (% yoy) 7 6 55 5 4 3 45 2 1 0 35 -1 -2 90 95 00 05 10 30 World GDP 40 World PMI 50 World PMI (index) 60

• •

65 60 55 50 45

Surveyed business conditions (index)

30 20 10 0
World

Industrial production (% 3m annualised)

Emerging Asia

-10 -20 Advanced economies -30 -40

USA 40 35 30 90 95 00 05 10

90

95

00

05

10

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World inflation – Loose monetary policy supports high commodity prices
• •
• •

Commodity prices have risen sharply on strong Asian demand and loose monetary policy globally. Further policy easing in the advanced economies would support high commodity prices. With policy settings still loose in most countries, higher headline inflation may become embedded in higher inflation expectations. At this stage, though, market estimates of inflation expectations have fallen given weaker activity in the advanced nations, although the risk of deflation is not being factored in as it was in 2008-09.

35 30 25 20 15 10 5 0

CPI (% 3m yoy)

Developing Asia

World -5 90 95 00 05 10

3.5 3.0 2.5 2.0 1.5

US 10-year breakeven inflation rate (%) Swap

500 450 400 350 300 250
Bond

World price index Energy

Food and other raw materials

200 150 100 50 Manufactured goods

1.0 0.5 0.0 00 02 04 06 08 10 12 14

0 90 95 00 05 10

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9 8 7 6 5 4 3 Actual 2 1 0 95 Current interest rate (%) 5.50 4. The market has moved away from pricing in an immediate cut at the next meeting.75 4.Market pricing of monetary policy – An emergency rate cut à la 2008 • Global events saw the front end of the yield curve price in an emergency rate cut along the lines seen during the worst point of the global financial crisis in 2008-09. Note that the entire yield curve is now lower than the cash rate.50 Cash 1Y 2Y 3Y 4Y 5Y Term 6Y 7Y 8Y 9Y 10Y -200 -250 95 97 99 01 03 05 07 09 11 6 / 51 . but it remains substantial. The market has modestly scaled back the expected reduction in rates. with about 100bp of rate cuts priced in over the next twelve months.00 3.75 RBA cash rate (%) 12-month ahead forecast derived from the futures and swap markets (aligned with outcomes) • • • 97 99 01 03 05 07 09 11 250 200 150 100 50 0 -50 -100 -150 Expected change in the cash rate over the next 12 months derived from the futures and swap markets (bp) 3.25 4. but is still expecting most of the reduction in rates to happen this year.00 4.

Channels for Europe/USA to affect Australia (1) Commodity demand – volumes & prices have held up surprisingly well (2) Banking linkages – no signs of strains at this point (3) Confidence – confidence was already low – too early to judge the impact. but worry most about the effect on jobs 7 / 51 .

Terms of trade (ratio of export to import prices) 130 120 110 100 90 80 70 • • • 60 50 40 1900 1925 1950 1975 2000 35 30 25 20 15 10 5 Exports of goods by country (smoothed % of total) Real GDP (% qoq annualised) Australia's major trading partners 10 China 5 0 USA -5 G3 (USA. especially China (75% of exports go to Asia with China at close to 30%). Material weakness in commodity demand would have major implications for the growth outlook in Australia and would trigger an aggressive policy response from the RBA. Direct trade links with Europe and the US are small (less than 5% of exports each). but prices have been steady to date. not Europe and the US • Direct trade links are dominated by Asia. whereas they collapsed in 2008-09. Japan & Euro area) 90 95 00 05 10 Euro area 0 90 95 00 05 10 -10 8 / 51 . We expected lower prices as flood-affected coal production returned to normal. Prices and volumes of Australia’s key commodities of iron ore and coal have been surprisingly resilient.(1) Commodity demand – Asia matters.

Commodity demand – Prices and volumes are surprisingly resilient 200 180 160 140 120 100 80 60 40 20 0 00 02 04 06 08 10 12 14 Australian export price 0 00 02 04 06 08 10 12 14 50 Australian export price 100 Spot price 150 200 Spot price Coal price (USD/t) 250 Iron ore price (USD/t) Export volumes (Mn t) 40 35 30 Iron ore 6 5 4 Exports (% of GDP) Iron ore 25 20 15 10 5 0 00 02 04 06 08 10 Coal Coal 3 2 Queensland floods 1 0 12 14 Natural gas 90 95 00 05 10 9 / 51 .

although not by as much as they did in 2007-09 and for different reasons. bank spreads have widened only because funding costs have not fallen as fast as the expected cash rate.0 3. That is.5 1.5 2. increasing the reliance on deposits and medium-term funding and reducing the reliance on short-term funding.5 0. In 2007-09.5 3.0 Oct-08 9 8 Interest rates (%) 3M BBSW Target cash rate 7 6 Smoothed 5 4 3 3M expected cash rate 00 02 04 06 08 10 12 0. Bank usage of the RBA cash facility hasn’t changed much. Note that European banks have already significantly scaled back their lending in Australia.0 03 04 05 06 07 08 09 10 11 2 10 / 51 .0 2.5 4. indicating no strains on local banks.0 4.0 1. Daily repos of private securities with the RBA by banks ($bn) 170 150 130 110 3-month BBSW less the expected cash rate (bp) • • 90 70 50 30 10 -10 00 02 04 06 08 10 12 • 5. with the slack taken up by the major trading banks and Asian banks. Banks have dramatically restructured their liability mix over recent years.(2) Banks – No funding stress at this point • Bank spreads have widened. wider spreads were driven by higher outright funding costs.

Banks – Bank bond yields have fallen although CDS is up 150 130 110 90 70 50 30 10 -10 02 04 06 08 10 3-year bank bond less swap (bp) 10 9 8 7 6 5 4 3 2 1 0 00 Interest rates (%) 3Y bank bond 3M swap 02 04 06 08 10 12 60 40 20 3-year AUD cross-currency basis swap (bp) 250 Average 5-year CDS for the 4 major banks (bp) 200 150 0 100 -20 -40 -60 00 02 04 06 08 10 50 0 03 04 05 06 07 08 09 10 11 11 / 51 .

Banks – Banks have restructured their funding & Europeans are departing Bank loan-deposit ratio (%) 180 160 140 120 100 80 60 40 20 0 90 95 00 05 10 Bank funding by type (% of total) 70 60 50 40 30 20 10 Long-term debt 0 90 95 00 05 10 Global financial crisis & aftermath Deposits Short-term debt Non-financial corporate bank debt by region (% of total corporate debt) 16 14 12 10 8 6 4 2 0 00 02 04 06 08 10 12 14 USA/Canada 64 80 Non-financial corporate bank debt by lender (% of total corporate debt ) 16 14 12 10 8 6 4 Europe & UK 78 76 74 Australia .other banks (RHS) Asia (incl Middle East & Africa) 72 70 68 66 Australia 4 major banks (LHS) 00 02 04 06 08 10 12 14 2 0 12 / 51 .

partly because of a slump in migration and an absence of first home-buyers. Even with solid jobs growth and solid wages growth we are assuming that household saving rises further to around 15% of income. Consumers are anxious given a string of natural disasters. the experience of the US/European consumer.(3) Confidence spillovers – Consumers are gloomy • Households have become more conservative over the past few years. but housing demand has weakened. Note that there has also been a structural shift away from retail goods to services (eg. the boom in overseas travel) and buying from overseas internet retailers. This is the biggest turnaround on record and the largest change of any country. lifting the saving rate from zero to 10%. fears about the carbon tax and soft equity and house prices. Supply constraints are still an issue. Measures of financial stress remain low and the key there remains unemployment. Real consumer spending (% yoy) 3 2 1 0 -1 -2 -3 -4 90 95 00 05 10 WMI monthly consumer confidence Surveyed consumer confidence (detrended index) Roy Morgan weekly consumer confidence • • 7 6 5 4 3 12 10 8 6 4 2 Real household income (% yoy) Total household income 2 1 0 -1 90 95 00 05 10 0 -2 -4 -6 90 95 00 05 10 Wages 13 / 51 .

Consumer caution – Consumers are saving more 25 Household saving rate (%) Consumer survey ."Wisest place for savings" (% of respondents) 60 20 50 40 30 20 10 Bank deposits. etc 15 Latest available estimates 10 5 0 Estimates as first published -5 60 70 80 90 00 10 Pay off mortgage 0 90 95 00 05 10 20 15 10 5 0 -5 -10 -15 -20 Real household wealth (% yoy) 12 10 Household bank deposits (% of household assets) / Term deposit rate less cash rate (pp) Household deposits 8 6 4 2 0 -2 -4 90 95 00 05 10 1Y term deposit rate less cash rate 90 95 00 05 10 14 / 51 .

Consumer caution – Financial stress depends on unemployment Mortgage payments on a new loan (estimated % of household income)* 45 40 35 30 25 20 4 8 6 12 10 US Bank residential mortgage arrears (% of loans) 15 10 5 0 80 85 90 95 00 05 10 Bankruptcies.10 0.20 0.30 0.05 0. debt arrangements.25 0.50 0.35 0. etc 2 Australia * assumes lowest available interest rate.25 0.40 0.15 Bankruptcies excluding small business Mainland states 0.30 0.10 0. 20% deposit and 25 year term 0 90 95 00 05 10 Mortgage reposessions (smoothed annualised % of households) 0.45 0. debt arrangements etc (annualised % of households) Bankruptcies.20 0.00 90 95 00 05 10 15 / 51 .00 90 95 00 05 10 New South Wales 0.15 0.05 0.

Consumer – Housing supply is constrained. but demand has weakened National house prices (% yoy) 25 500 450 Annual change in the population and the housing stock ('000) 20 400 350 Change in the population 15 300 10 250 200 5 150 100 0 50 -5 90 95 00 05 10 Change in the housing stock 50 60 70 80 90 00 10 0 Capital city house price .distribution of median prices ($'000) 600 580 560 540 520 500 480 460 440 420 400 08 09 10 11 12 Middle 60% of the market Bottom 20% of the market Top 20% of the market Home loans written each month ($bn) 10 9 8 7 6 5 4 3 2 1 0 90 95 00 05 10 First home-buyers Other home-buyers Increase in a Govt subsidy Investors 16 / 51 .

employment (index) 20 15 10 3 2 1 0 -1 -2 -3 -4 00 02 04 06 08 10 Hours worked 5 2 0 -5 -10 Employment NAB employment (leading by 6 months) -15 -20 -25 -30 00 02 04 06 08 10 12 14 Employment 1 0 -1 -2 -3 12 14 17 / 51 . Usually business confidence tracks consumer confidence more closely. 40 30 20 10 NAB business survey . so it is surprising that it hasn’t fallen by more. suggesting firms are working their existing employees harder rather than putting on new staff. Business confidence can also be influenced by share prices. The hours worked data are poorly measured. Need to watch if companies decide to delay hiring staff. but show some signs of this in that hours worked have risen as employment has been softer.Business – Need to watch if companies freeze hiring plans • Surveyed business confidence and conditions have both fallen to around average levels.business confidence & conditions (net balance) • 0 -10 -20 -30 -40 -50 90 95 00 05 10 Business conditions Business confidence 6 5 4 Employment & total hours worked (% yoy) 5 4 3 Employment (% yoy) NAB business survey .

Dutch disease (1) Mining versus the rest – the rest of the economy is actually growing (2) Manufacturing – struggling before the resources boom (3) Retail sales – Australians take to the internet & head overseas (4) Tourism – an exodus of Australians 18 / 51 .

the economy outside the mining sector is actually growing. or (2) mining net exports and investment. This is true regardless of whether you adjust GDP to exclude either: (1) mining production.(1) Dutch disease – The non-mining sector is actually growing • • Contrary to popular perceptions. The same also holds if you exclude mining from total employment. Real GDP (% yoy) 7 6 5 4 3 2 1 0 -1 -2 -3 90 95 00 05 10 GDP Excluding mining production • Total employment (% yoy) 5 4 3 2 1 0 -1 -2 -3 90 95 00 05 10 Exluding mining 19 / 51 .

The benefit of the boom for the rest of Australia $1 in export earnings = 25c on domestic services + 15-20c on government taxes/royalties + 10c on domestic wages bill + 5-10c on domestic share-holders + 35-45c in offshore returns which => a 55-65c boost to the domestic economy 20 / 51 .

(2) Dutch disease – Manufacturing has been in decline for decades Production (% of GDP) 120 110 100 Real exchange rate 90 80 70 60 1950 100 90 80 70 60 1960 1970 1980 1990 2000 2010 0 1900 1920 1940 1960 1980 2000 5 10 Mining Manufacturing output (index) Real exchange rate (index) 140 130 Manufacturing 120 110 15 20 25 Manufacturing 25 Manufacturing exports and estimated domestic sales ($bn real) Manufacturing employment (% of total employment) 30 25 20 15 20 15 Estimated domestic sales 10 10 5 Exports 0 80 85 90 95 00 05 10 5 0 70 75 80 85 90 95 00 05 10 21 / 51 .

75 0.95 0.(3) Dutch disease – Retail sales struggling to compete on many fronts • Retailers have been soft for some time as they have lost market share because of: (1) a shift to spending on services. excluding autos (% yoy) 10 8 6 4 2 Retail goods 0 -2 00 02 04 06 08 10 12 14 • Spending on services • 100 90 80 70 60 50 40 30 20 10 0 04 Weekly google searches from Australia for "free shipping" (index) Searches AUD per USD 1.85 100 0 90 95 00 05 10 05 06 07 08 09 10 11 12 22 / 51 .05 600 500 400 300 200 0. The Bureau of Statistics also believes it may be underestimating spending on telecommunication services. and (2) Australians buying goods from overseas internet retailers.55 Australians taking overseas holidays to see family/friends or for a vacation (Smoothed '000 per month) AUD 0. but using survey and overseas data we put the loss in market share at about 5% of sales. Real consumer spending by type. There are no hard statistics on overseas internet purchases.15 1. The increase in spending on services includes double-digit growth in overseas travel.65 0.25 1.

0 -10 90 95 00 05 10 1998 2000 2002 2004 2006 2008 2010 Sydney Olympics 4.0 2.5 Tourism output (% share of financial-year GDP) Nominal tourism output (% yoy) 20 18 16 14 12 10 8 6 4 2 0 1998 2000 2002 2004 2006 2008 2010 100 0 80 300 200 Sydney Olympics 700 600 500 400 Overseas arrivals and departures (smoothed '000) Overseas tourists arriving in Australia Australians travelling overseas 85 90 95 00 05 10 23 / 51 .0 1.5 2.5 3.5 1.(4) Dutch disease – Tourism is small.0 0.0 3. but suffers from a high dollar Domestic accommodation revenue (% yoy) 30 25 20 15 10 5 0 -5 0.

then the resources boom should see higher inflation re-emerge as the main problem with higher interest rates to follow (1) The resources boom – still in full swing (2) Inflation – poor productivity and looming skill shortages (3) Interest rates – hikes back on the agenda 24 / 51 .What if the world doesn’t fall apart? If the fall-out from global events is limited.

(1) Resources boom – Mining underpins the boom in investment 8 7 6 5 4 3 2 1 0 60 70 80 90 00 10 Unfinished work Work done Non-residential construction (% of GDP) Nominal business investment (% yoy) 50 Implied by the Capex Survey 40 30 20 10 0 -10 -20 80 85 90 95 00 05 10 Business investment pipeline (% of GDP) 25 16 15 Business investment (% of GDP) Investment Business debt (% yoy) 35 30 25 20 15 10 5 0 Debt -5 -10 20 Projects under consideration 14 13 12 11 15 10 10 9 5 Committed projects 0 00 02 04 06 08 10 12 8 7 80 85 90 95 00 05 10 25 / 51 .

Major investment projects in Australia 26 / 51 .Resources boom .

than suggested by these relationships. and by a larger amount.” RBA Assistant Governor (Economic) Lowe 27 / 51 .(2) Inflation – Pressure still in the system “The general picture that one gets from [our] analysis [of the 2005-09 period] is that underlying inflation in Australia was slower to pick up than suggested by the historical relationships. it did so more quickly. but when it did eventually pick up.

GDP measure of wage rates & nominal unit labour costs (%yoy) 10 8 Wages 6 4 2 0 -2 Nominal unit labour costs -4 90 95 00 05 10 • 6 Consumer expected inflation over the next 12 months (%) 2600 2500 2400 Index of labour productivity 5 4 2300 2200 2100 Trend 3 2 2000 1 RBA inflation target 1900 1800 0 90 95 00 05 10 90 95 00 05 10 28 / 51 . such that there is no productivity offset to higher wages (poor productivity is apparent across a range of productivity measures and is weak across industries).Wages are back to normal. As unemployment falls further we see wages remaining strong and picking up further. The problem for many companies is that productivity performance is poor. but with no productivity offset • Wage pauses/freezes are behind us and wages are back growing at a 4-5% pace on a variety of measures.

Unemployment continues to trend lower and the supply of labour is growing more slowly as net overseas migration has slumped (fewer people are arriving and more Australians are leaving). The reduced supply of labour is important because foreign-born workers have accounted for about two-thirds of the growth in employment over the past year.availability of labour (net balance) Harder to get Total 20 0 -20 -40 -60 -80 70 75 80 85 90 95 00 05 10 Easier to get 29 / 51 . 80 70 60 50 40 30 20 10 0 70 75 80 85 90 95 00 05 10 NAB business survey .labour as a significant constraint (% of firms) • • Unemployment rate (%) 12 10 8 6 4 2 Excluding those unemployed for a year or more 0 90 95 00 05 10 100 80 60 40 ACCI/WBC manufacturing survey .Skill shortages – Likely to emerge late 2011/early 2012 • Business surveys suggest skill shortages are likely to emerge later this year/early next year (there are already reports of shortages in the resources sector).

0 0.0 80 85 90 95 00 05 10 6 5 4 3 2 1 0 -1 -2 -3 -4 90 Employment (% 3M yoy) Total employment Contribution to employment growth from people born overseas 95 00 05 10 30 / 51 .0 2.5 0.0 Working age population (% qoq annualised) 200 150 100 50 0 70 80 90 00 10 1.Skill shortages – Population growth has slumped 350 300 250 Annual change in net overseas migration ('000) 3.5 2.5 1.

The higher dollar is having a restraining effect on inflation.7 2 Inflation 1 0 90 95 00 05 10 0.8 Unemployment 8 3 4 2 1 0 90 95 00 05 10 Inflation 2 0 3 0.2 AUD 1.6 0. and (2) a mark-up model of inflation.5 0. 8 7 6 5 4 3 2 1 0 90 95 00 05 10 RBA Phillips Curve model prediction Actual Underlying inflation (% annualised) • • 7 6 5 4 RBA underlying inflation (% yoy) Unemployment (%) 12 7 10 6 5 4 6 RBA underlying inflation (% yoy) AUD per USD 1. These models suggest inflation is likely to be around 3% or higher over the next couple of years. but the tighter labour market and higher inflation expectations are driving inflation higher.9 0.1 1 0.Inflation – Likely to breach the RBA’s target band • Underlying inflation has troughed at 2¼% and is likely to reach the top of the RBA’s 2-3% target band by the end of this year (it is already above 3% on an annualised basis in the first half of 2011).4 31 / 51 . This is evident in two RBA inflation models: (1) an expectationsaugmented Phillips Curve model.

8 3.2 3.7 3.1 2.6 3¼% 4.2 3.9 2.1 2.1 2.0 2.9 3.5 3.5 2.9 2.2 3.7 3.2 Unit labour costs 32 / 51 .7 2.6 3.5 2.8 2.5 3.2 2.2 4.3 4.0 2.9 2.6 2.7 3.9 2.5 2.5 3.2 3.6 3.0 3.6 2.1 3.9 3.9 3.RBA inflation models – Sub-5% unemployment points to >3% inflation An unemployment rate in the 4s is inconsistent with the 2-3% target band.3 2.0 3.3 3.6 3.4 3.5 3.4 3.6 2.8 2.1 2.3 7 6 5 4 2¾% 3.8 Nominal unit labour costs (% yoy) 10 8 6 4 3½% 4.8 2.8 3.3 3.8 2.1 3.8 2.2 3. assuming no change in the exchange rate Predicted annual underlying inflation based on Phillips Curve model (%) Breakeven inflation rate: 2% 2¼% Unemployment rate: 4% 4¼% 4½% 4¾% 5% 5¼% 5½% 5¾% 6% 8 7 6 5 4 3 3 2 1 0 90 95 00 05 10 2 1 0 90 95 00 05 10 Underlying inflation 0 -2 -4 2 Mark-up model prediction Actual RBA trimmed mean CPI (%qoq annualised) 2½% 3.3 2.4 3.0 2.3 3.5 RBA trimmed mean CPI (% yoy) 3% 4.

Parliamentary testimony 33 / 51 . if it can. though. rather than add to that turbulence by starting to change our settings”.(3) Interest rates – The RBA may take out insurance The RBA has cut in response to confidence shocks • -50bp in Dec 1987 after the Oct ‘87 stock market crash (started to raise rates in April 1988) • -25bp in Dec 1998 after the Aug/Sep 1998 Russian debt default/LTCM crisis (started raising rates in Nov 1999) • -25bp in Oct 2001 after 9/11 (it cut again in Dec 2001 before hiking in May 2002) At this point. RBA Governor Stevens. “there are periods of tremendous turbulence when I think it is a very good thing for policy to just sit still.

in 2009 than the RBA. • Leaked cable reporting tension between the Treasury. who are more worried about inflation. and the private-sector Board-members. • Former Board-member ANU Professor McKibbin has called for: (1) replacing privatesector board-members with more expert representation. and (2) excluding the Secretary to the Treasury.Interest rates – Reports of Board tension • Reports of tension between Bank staff. 34 / 51 . who wanted more aggressive action. by cutting rates towards zero.

We see no change in rates over the rest of this year. Surveyed lending standards for companies have eased. though. while banks have trimmed mortgage rates. Underlying inflation (% yoy) 14 12 % • Underlying inflation 10 Cash rate 8 6 4 2 RBA inflation target 0 90 95 00 05 RBA forecasts • 10 7 6 7 6 Real GDP(% yoy) Rolling year-ahead RBA GDP forecast Rolling year-ahead RBA inflation forecast 5 4 3 2 1 0 90 95 00 05 10 RBA inflation target Actual inflation 5 4 3 2 1 0 -1 -2 -3 90 95 00 05 10 GDP growth as first reported 35 / 51 . although an insurance rate cut is possible. The real exchange rate is high and credit growth is low (although this is partly because companies are using retained earnings to fund investment).Interest rates – No change this year. and/or (3) lower confidence led to weaker activity and higher unemployment. hikes in 2012 – cuts need big spillovers • The RBA has seen higher-than-expected inflation and weakerthan-expected growth. although the latter largely reflects the temporary impact of natural disasters in Queensland. We forecast higher rates with 5. A reversal would likely happen if: (1) bank funding froze up.5% by the end of 2012 assuming limited fall-out from European/US events. Financial conditions are generally on the tight side of neutral. (2) commodity demand slumped.

Interest rates – Financial conditions generally on the tight side 130 120 110 100 20 AUD real exchange rate (index) 35 30 25 Total private-sector credit (%6m annualised) 90 80 70 60 50 40 80 85 90 95 00 05 10 15 10 5 0 -5 80 85 90 95 00 05 10 50 40 30 Surveyed lending standards (net balance of respondents reporting tighter standards) Manufacturing (ACCI/WBC survey) Mortgage interest rates (%) 10 9 8 Standard variable 20 10 0 -10 -20 90 95 00 05 10 All business (NAB survey) 7 6 5 4 00 02 04 06 08 10 12 14 3Y fixed Discounted variable 36 / 51 .

1 1½ 2½ 3 3½ 4 4½ 1¾ 2.4 4.1 4.1 3.6 3.9 6.Cash rate = 2½% real rate + inflation forecast + ½*(inflation forecast – RBA 2½% target) + ½*output gap Inflation forecast (%): Output gap (%) -2 -1 Flat 1 2 1 1¾ 2¼ 2¾ 3¼ 3¾ 1¼ 2.4 6.4 3 4¾ 5¼ 5¾ 6¼ 6¾ 3¼ 5.9 7.9 2 3¼ 3¾ 4¼ 4¾ 5¼ 2¼ 3.9 5.6 5.9 3.6 3.9 2 3¼ 3¾ 4¼ 4¾ 5¼ 2¼ 3.1 6.6 7.4 5.6 6.6 4.6 6.1 5.4 5.4 4.4 3.4 3 4¾ 5¼ 5¾ 6¼ 6¾ 3¼ 5.1 2.9 6.9 6.6 2½ 4 4½ 5 5½ 6 2¾ 4.9 4.9 4 6¼ 6¾ 7¼ 7¾ 8¼ 37 / 51 .6 5.1 2.1 6.Interest rates – A Taylor rule scenario analysis points to higher interest rates If the resources boom remains intact.1 4.1 5.4 6.6 4.9 4.1 3½ 5½ 6 6½ 7 7½ 3¾ 5.6 7.1 5.4 4.9 7.9 5.9 6.1 1½ 2½ 3 3½ 4 4½ 1¾ 2.4 7.4 7.9 4 6¼ 6¾ 7¼ 7¾ 8¼ Market pricing of a big rate cut => low inflation and/or high unemployment Inflation forecast (%): Output gap (%) -2 -1 Flat 1 2 1 1¾ 2¼ 2¾ 3¼ 3¾ 1¼ 2.9 3.6 4.6 2½ 4 4½ 5 5½ 6 2¾ 4.1 3.1 5.4 4. inflation points to higher rates Calibrated Taylor rule .1 3½ 5½ 6 6½ 7 7½ 3¾ 5.4 3.6 4.

Other key risks (1) China – the biggest medium-term uncertainty (2) House prices / household leverage – the perennial favourite likely needs materially higher unemployment to pop the bubble but there could be a conscious deleveraging 38 / 51 .

policy interest rate (%) and required reserve ratio (%) China .production (%3m yoy) Steel 10 5 Excluding food 0 -10 Electricity 0 -5 90 95 00 05 10 -20 90 95 00 05 10 39 / 51 .CPI (% yoy) 40 30 20 10 China .(1) China – China may overdo it in trying to contain inflation 25 China .real GDP (% growth) 25 Annualised quarterly growth 20 Required reserve ratio 20 Annual growth 15 15 10 10 5 Policy interest rate 0 90 95 00 05 10 5 0 90 95 00 05 10 30 25 20 15 China .

China – Australia is heavily exposed 70 60 50 Exports by country (% of total exports of goods) 12 10 8 Exports by country (% of Australia's GDP) UK UK 40 30 20 10 0 1900 Japan China (plus HK) 6 4 2 0 1900 Japan China (plus HK) India India 1925 1950 1975 2000 1925 1950 1975 2000 35 30 Exports of goods to China and HK as a share of each country's GDP (%) 6 5 Exports by country and mining investment (% of Australia's GDP) Exports to China (plus HK) 25 20 15 10 4 3 2 Mining investment 5 0 South Africa Iran Indonesia Argentina Japan Singapore Saudi Arabia Philippines Germany Korea Thailand Kuwait Vietnam Australia Chile Israel UAE NZ Malaysia Belgium 1 0 1900 1925 1950 1975 2000 40 / 51 .

(2) House prices & leverage – Households are the Achilles heel 500 450 400 350 300 250 200 150 100 50 0 20 60 40 100 Economy-wide debt (% of GDP) 120 Household debt (% of GDP) 1980 1990 2000 2010 1980 1990 2000 2010 80 0 Australia Germany USA UK Japan Germany Japan USA UK Australia 250 Public-sector debt (% of GDP) 250 Corporate debt (% of GDP) 200 200 1980 1990 2000 2010 150 1980 1990 2000 2010 150 100 100 50 50 0 Australia Germany UK USA Japan 0 USA Australia Germany UK Japan 41 / 51 .

0 3.5 0.0 90 95 00 05 10 20 50 60 70 80 90 00 10 42 / 51 .5 4.0 40 0.House prices & leverage – Prices are out of line with the fundamentals Residential mortgage debt (% 3m annualised) 30 25 20 15 10 5 0 90 95 00 05 10 180 160 140 120 100 80 60 40 20 0 50 60 70 80 90 00 10 US Australia Household debt (% of annual household income) 140 House prices (June-07 = 100) China 5.0 1.0 2.0 4.5 USA Existing house price (multiple of annual household income) 120 Australia Euro area 100 80 60 2.5 3.5 1.

An early return to surplus poses a different set of challenges to those faced by other countries. Underlying cash Budget balance (% of GDP) 5 4 3 2 1 0 -1 -2 -3 -4 -5 60 70 80 90 00 10 Government forecast • • Commonwealth plus State Budget balance (% of GDP) 4 2 0 -2 25 Bonds on issue (% of GDP) 20 Commonwealth Government 15 10 -4 Smoothed State Governments 5 -6 -8 90 95 00 05 10 0 90 95 00 05 10 43 / 51 . with the Government keeping enough bonds on issue (12-14% of GDP versus the OECD average of 100%). although history shows that it is very hard to accurately predict where the Budget will end up.Fiscal policy – A forecast return to a small surplus • A large range of small cuts and the resources boom drive the Budget’s return to a small surplus in 2012-13. Legislation is yet to pass for the carbon and mining taxes. Political support for a macro stabilisation fund is still lukewarm at best. which commence in July 2012. The forecast turnaround in the Budget is one of the biggest on record and implies fiscal policy will be a large dampener on growth.

The Greens control the Senate. ALP primary vote in Federal elections.Politics – Minority ALP Government could face an early election • The minority ALP Government relies on 1 Green. The ALP is very likely to lose the next election . Also. An ALP MP is being investigated by Fair Work Australia and NSW police for alleged misuse of credit cards whilst a union official. The next election is due Aug-November 2013. and 2 ex-National Party (two other independents support the Liberal Party). 1 independent may withdraw his support for the ALP if there are no reforms to poker machines by May 2012. If charges were brought and if there was a criminal conviction with a sentence of 1 year or more.primary voting intentions (smoothed %) 60 50 40 30 20 10 NSW split from Federal ALP Latest opinion poll ALP 20 10 0 1901 1911 1921 1931 1941 1951 1961 1971 1981 1991 2001 2011 Election year 0 90 95 00 05 10 44 / 51 .polls show the lowest primary vote support for the ALP since Australia split from England in 1901. 1 ex-Green. plus in the latest opinion poll (%) 60 Liberal/NP 50 40 30 150 140 130 Consumer confidence (smoothed index) ALP voters • 120 110 100 90 80 70 60 50 80 85 90 95 00 05 10 Coalition voters • • Newspoll survey . then this would force a by-election and then likely a general election.

Exchange rate – Strong fundamental support • Despite market wobbles associated with concerns over global growth and European sovereign debt. It continues to be supported by the record high terms of trade.2 1. remains tolerant of a higher exchange rate.4 0.8 0.2 0. the Australian dollar has held onto the strong gains made over the past few years and remains well above parity with the USD.0 0. as well as wide interest rate spreads.0 80 10 8 6 AUD (US dollars) • • • 85 90 95 00 05 10 15 130 120 110 100 90 80 70 60 50 40 Aus-US 2yr bond spread (%) REER 4 2 0 ToT -2 -4 80 85 90 95 00 05 10 15 -6 80 85 90 95 00 05 10 15 45 / 51 . though. AUD real exchange rate and the terms of trade (Index) 1.4 1. which reflects ongoing strength in bulk commodity prices. Our expectation is that the AUD will continue to trade above parity given that the Federal Reserve has committed to keeping rates low until 2013.6 0. comfortable with the stronger currency taking some of the heat out of the economy. The RBA.

Exchange rate – Bond buying by central banks matters most 12 10 8 6 4 2 0 -2 -4 90 95 00 05 10 Net foreign purchases of Australian bonds (rolling annual % of GDP) 12 10 8 6 4 2 0 -2 -4 90 95 00 05 10 Net foreign purchases of Australian equities (rolling annual % of GDP) 80 70 60 50 40 30 20 10 0 90 Foreign ownership of domestically-issued bonds. excluding cross-holdings and bonds held by the RBA and AOFM (% of each total) Commonwealth 120 100 80 Foreign holdings of Commonwealth bonds (% yoy) and central bank reserves held in "other" currencies (% yoy) State G 60 t Total overseas holdings of Commonwealth bonds 40 20 Banks 0 -20 -40 Central bank reserves held in "other" currencies 00 02 04 06 08 10 12 14 95 00 05 10 46 / 51 .

For 2012. while inflation looks set to nudge down to around 2% by end-2012.5% by end-2011 as the impact of tax increases drops out of the calculation. returning the cash rate from 2. Headline inflation will drop back towards 2. The RBNZ is forecasting steep rate rises in 2012 and 2013 and has said that it could hike this year.5% to a predisaster level of 3% (the window for a September hike seems closed by extreme volatility in global markets).New Zealand – RBNZ forecasts steep interest rate rises • GDP growth is set to accelerate from around 3% at end-2011 to nearly 5% by end-2012 as the economy gets a boost from the rebuilding effort post the earthquakes. We expect the first hike to come in December. we see more hikes and are factoring in a 4% cash rate by the end of the year. 10 9 8 June MPS projection for 90 day bills Interest rate (%) • 7 6 5 4 3 2 1 0 00 02 04 06 08 10 12 14 March MPS projection for 90 day bills Cash rate • 6 5 4 CPI (% yoy) Actual March MPS forecast 8 6 4 2 Real GDP (% yoy) Actual June MPS forecast 3 0 2 -2 1 0 00 02 04 06 08 10 12 14 June MPS projection Excluding rebuild -4 -6 00 02 04 06 08 10 12 14 47 / 51 .

Appendix 1 – Key forecasts 48 / 51 .

Appendix 2 – Structure of the economy 49 / 51 .

50 / 51 .

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