130710 Australia's R-word - Rebalancing not Recession.pdf

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abcGlobal Research

Australias economy needs torebalance from mining to non-mining

led growth

The process is being made moreurgent by the slowdown in China and

the fall in commodity prices

But we think Australia will avoid asignificant downturn or a recession,

helped by a weakening AUD

Mind the mining gap

Australias growth has been uneven in recent years; with the

mining sector booming, other sectors were held back. As the

mining story slows, other sectors need to pick up to support

Australias growth (we have been calling thisAustralias great

rebalancing act, 7 December 2012).

There are some early signs that rebalancing is gradually

happening, although it has been slower than expected. This

reflects that it has been hampered by the AUD, which had

remained high until recently, and by households that have

continued to save more than expected. Asias growth has

also been weaker than expected, dampening confidence (see

ourAsian Economics Quarterly Q3 2013: Asias bitter

medicine, 9 July).

We remain optimistic that Australia will pull off its

rebalancing, although growth is likely to be below trend this

year (2.5%), before heading towards trend next year (2.8%).

The RBA may cut rates further to support this rebalancing.

Our optimism reflects that: Australias main trading partnersare still the worlds fastest-growing economies; there are few

imbalances in the local economy; the bulk of the local

economy is outside of mining; policymakers still have room

to move on the monetary and fiscal policy fronts; and the

AUD could fall further if necessary.

Key risks are a sharp fall in commodity prices, due to slower

Asian growth, or a ramp-up in global commodity supply.

However, we remain confident that local policymakers have

room to loosen policy and the flexible AUD could provide

support in the face of a negative global surprise. While a

recession can never be completely ruled out, we think

Australias R-word is more likely to be rebalancing.

Economics

Australia

Australias R-word:Rebalancing notRecession

10 July 2013

Paul Bloxham

Chief Economist, Australia & New Zealand

HSBC Bank Australia Limited

+61 2 9255 2635 [email protected]

Adam Richardson

Economist



View HSBC Global Research at: http://www.research.hsbc.com

Issuer of report: HSBC Bank Australia Limited

Disclaimer & DisclosuresThis report must be read with thedisclosures and the analyst certificationsin the Disclosure appendix, and with theDisclaimer, which forms part of it
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Mining booms three stages

Australias economy has been supported in recent

years by a mining boom. This has been a key

reason for the economys outperformance

compared with the rest of the developed world.

The boom can be thought of as occurring in three

overlapping stages (we outlined these in

Downunder digest: Reports of the mining booms

death greatly exaggerated, 26 July 2012). First,

commodity prices rise, boosting incomes. Second,

the high level of commodity prices motivates

mining companies to invest significant amounts in

new capacity. Finally, there is a ramp-up in

resources exports as new capacity comes online.

The first stage is over, the second stage is winding

down, but the third stage is only just ramping up.

Commodity prices havepeaked, so the first stageis over

The first stage occurred between 2003 and 2011,

with a brief interruption during the global financial

crisis in 2008. Thanks to Chinas large boost to

government spending after the global financial

crisis, commodity prices bounced back in 2009,

after a brief and sharp fall in 2008 (Chart 1).

1. Commodity prices have passed the peak, but are still high

Source: RBA

Mining slowing, notcollapsing

Mining investment is near its peak as a share of the Australian

economy, as fewer new mining construction projects are started

Looking beyond this, the economy will get support from rising

resource exports, as new projects come online

But, unsurprisingly, the overall mining contribution to growth will

be less than it has been in recent years, when it had been an

extraordinarily large share of Australias GDP growth story
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At the peak, in mid-2011, the average price of the

basket of commodities that Australia exports was

370% higher than it was in 2000 in USD terms.

Commodity prices have fallen by 27% since then,

though they remain historically high, at around

240% above the level they were at in 2000 in

USD terms.

A significant AUD appreciation between Q1 2009

and Q2 2011 helped Australia to absorb the positive

shock to local incomes from the rise in commodityprices, particularly the jump in prices after the global

financial crisis. As a result, commodity prices rose

by less in AUD terms over recent years than they

had prior to the global financial crisis, dampening

the impact on local incomes.

The first stage boosted Australias income growth

most significantly in the mid-2000s. Nominal

GDP grew by 8.0% a year from 2004 to 2007

(Chart 2). It slowed to 6.4% between 2008 and

2011, and we expect nominal GDP growth will

track below its long-run average in the coming

four years, at closer to 5%, as global growth is

more constrained and Australias terms of trade

are expected to gradually decline. The first stage

of the mining boom is over.

2. Nominal GDP is slowing as the commodity price boom is over

Source: ABS, HSBC estimates

Investment boom plateauing,so the second stage is ending,too

In response to the high level of commodity prices,

mining companies increased their investment in

the resources sector. In 2008, this saw engineering

construction contribute about 1ppt to Australias

GDP growth and provide significant support for

the economy in the face of the global financial

crisis. This was a big deal at the time, but therewas significantly more to come.

The global financial crisis of 2008-09 temporarily

disrupted progress, but the ramp-up in investment

that followed in 2011 and 2012 was much larger

than the previous boost. It was led by a substantial

pick-up in the construction of Liquefied Natural

Gas (LNG) projects in Australia. In 2011 and

2012, engineering construction grew by around

40% a year and contributed over half of all GDP

growth in the economy. This is despite the mining

sector (including the sectors immediately

downstream from the mining investment boom)

accounting for less than 20% of the overall

economy (Chart 3).

3. Mining investment contribution slowed after the boom

Source: ABS

This stage of the mining story is now slowing. We

believe this should not be a surprise, given the

extraordinary pace of growth in mining

investment over the past couple of years. For


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investment to continue to grow would have

required more and more new (and larger) projects

to enter the pipeline. This would have been

unrealistic, in our view. Indeed, because Australia

has been doing so much investment, the cost of

new investment has risen substantially as

companies have been competing for labour and

capital, which has also discouraged new

investment proposals.

Mining investment is set to peak as a share of the

Australian economy this year. The precise timing

is difficult to determine due to the lumpy nature of

these large projects. A guide to the likely timing

of the peak is the Australian capital expenditure

survey, which aggregates responses from firms

about investment spending plans. The RBA has

also provided its own forecasts, based on publicly

available information, as well as its own

confidential liaison. Both, the last set of available

RBA forecasts and the numbers from the last

capital expenditure survey suggest that mining

investment will plateau over the coming year,

rather than peak and fall sharply (Chart 4).

4. Investment should plateau, but not plummet

Source: ABS, RBA, HSBC estimates

Beyond this period, we expect mining investment

will fall and be a drag on economic growth.

However, this does not imply that mining is

necessarily an overall drag on the economy. After

all, this capacity has been built for a reason to

boost Australias resources exports.

Third stage is yet to come, asthe export boom is justramping up

The third stage of the mining story is only just

ramping up. Of the three key commodities in

Australias resources story, iron ore and coal exports

have already begun to ramp up, while LNG has yet

to pick up strongly. However, the large driver of the

forthcoming increase in resources exports is

expected to be LNG (Chart 5). After all, aroundthree-quarters of the capacity build in recent years

has been to produce LNG. Government estimates

based on capacity under construction suggest that

exports of LNG will rise by around 400% between

2014 and 2018.

5. Massive ramp-up in resource exports is just starting

Source: Australian Treasury

Putting it all togetherAdding up the overall mining story suggests we

have passed the peak of the positive contribution

of mining to Australias economic growth, but

there is likely to be modest support for growth yet

to come. This slowdown is expected because the

first and second stages of the mining boom are

likely to have provided a larger boost to growth

than the expected boost from the third stage.

In real terms we expect the mining sector willcontinue to make a modest contribution to overall

GDP growth. This is mostly because resources


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exports are a much larger share of GDP than mining

investment: so while mining investment is set to

decline in coming years, we expect this to be more

than offset by a rise in resources exports (Chart 6).

6. Mining sector should contribute positively in real terms


But this is not the full story. A large part of the

boost to the economy from the mining run-up in

recent years came from rising commodity prices

(stage one of the mining boom). If there was alarge fall in commodity prices, this would be a

drag on the nominal economy. That is, the run-up

in commodity prices boosts incomes, but a fall in

prices would work in the other direction.

Much depends on the commodity price outlook.

We remain of the view that commodity prices will

not fall back to the low levels of the 1980s and

1990s. We discuss this view in detail:

Commodities and the global economy: Are

current high prices the new normal?, 8 August

2012. In short, we expect the shifting composition

of global growth towards the emerging world

means global growth is now more commodity

intensive as these economies have substantial

infrastructure requirements.

However, we do expect commodity prices have

passed their peaks, which means that they are now

a modest drag on income growth. Our working

assumption for Australias terms of trade is that

they remain structurally high. We expect them to

cycle around a new higher mean than in the past,

but to edge downwards over the next couple of

years (Chart 7). Clearly, this is an important

assumption and we discuss the risks in the final

chapter, below.

7. Commodity prices to cycle around a new higher mean


With this working assumption for the terms of

trade, we believe that the mining sectors nominal

share of the Australian economy is likely to edge

downwards in the next few years, although it is

expected to remain significantly higher than it was

in the 1990s and early 2000s (Chart 8). In broad

terms, this shift in Australias economy matches

the shift in the composition of global growth to

being more driven by emerging economies. For

Australia, the investment share is forecast to fall,

but this is expected to be largely offset by a rise in

export values.

8. In nominal terms, mining is expected to edge downwards

Source:ABS, HSBC estimates
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Overall, our central view remains that mining is

slowing, not collapsing, with the forthcoming fall

in mining investment expected to be more than

offset (in real terms) by a rise in exports, as new

capacity comes online.


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Non-mining was held back

The non-mining sectors of the Australian

economy have generally been held back in recent

years to make way for the mining boom.

Above-neutral interest rates in 2011 were part of

the story, as they held back the household sector.

The other key factor holding back the non-mining

sectors had been the high AUD. Until mid-April

2013 the AUD had been around 30-year highs on

a trade-weighted basis, despite falls in the terms

of trade through last year, which typically should

see the AUD decline.

Official data make it difficult to track conditions

in the mining versus non-mining sectors on a

timely basis, but it is possible to come up with

estimates using annual GDP numbers and a

technique developed by the RBA. We use this

method in Chart 9, which shows clearly that

growth in the non-mining sectors of the Australian

economy has been well below average in the pastfew years as the mining sector has been the main

driver of growth.

9. Growth in the past couple of years was uneven

Source: ABS

Given the slowdown in the mining sector this

year, other sectors of the economy need to pick up

and take over as drivers of local growth.

Importantly, over 80% of Australias economy is

not directly exposed to the mining boom. The

bulk of the Australian economy is services, as is

the case in most developed nations (Chart 10).

Many of these sectors are interest rate and

exchange rate sensitive and there are already signs

that conditions are gradually improving in these

sectors, given the low RBA cash rate. The recent

Growth should continueto rebalance

As mining slows, we expect the other sectors, which account for

around 80% of the economy, to take over as drivers of growth

Some of the interest rate-sensitive sectors of the economy,

including housing, have already started to lift

The recent AUD depreciation should help rebalance growth, as it

makes the trade-exposed sectors more competitive


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fall in the AUD is expected to provide further

support for exchange rate-sensitive sectors.

10. The bulk of the economy is services, not mining

Source: RBA

Rates right for rebalancing

Monetary policy settings are currently primed to

lift the non-mining sectors of the economy. The

RBA has already delivered 200 basis points of

cuts in the past two years, which have largely

been passed through into lower borrowing costs

for businesses and households (Chart 11). The

cash rate is at its lowest level in over 53 years and

mortgage rates are 120bps below average.

11. Mortgage rates are now at well below neutral levels

Source: RBA

Our empirical modelling suggests that cash rate

changes typically have a significant impact of

growth in Australia (seeDownunder digest:

Australias powerful policy tools, 13 January

2012), in contrast to many other developed

economies where conventional policy options are

no longer available. Estimates suggest that a

100bps cut in the cash rate boosts GDP by +0.9%,

chiefly through higher household consumption

and dwelling investment (Chart 12).

12. Australias cash rate setting is powerful

Source: HSBC estimates

In addition to the role of interest rates, the

currency is also likely to support a rebalancing of

the Australian economy. The AUD has fallen

significantly in recent months.

During the mining investment boom, the

exchange rate appreciation played a buffering

role, dampening the positive shock to local

incomes and spreading the benefits of high

commodity prices by boosting the purchasing

power of households over internationally

produced goods, services and assets, effectively

pushing local demand offshore.

As mining investment cools, the exchange rate

will likely again play its traditional buffering role.

A lower exchange rate should help to rebalance

production towards the domestic economy.

A lower currency improves the competitiveness of

Australias exporters and relative price shifts

encourage greater consumption spending withinAustralia, while the tourism and education sectors

will also get a boost from a lower exchange rate.

0

2

4

6

8

10

12

1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013

Cash rate Effective mortgage rate

% Variable mortgage rates and nominal cash rate

Responses to 100 bp Cut in Cash RateImpact after 6 quarters

0.90.5

8.7

0

2

4

6

8

GDP

(expenditure)

Household

Consumption

Dwelling

investment

%
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This mechanism was somewhat stymied in late

2012 and early 2013 as the AUD remained around

30-year highs (Chart 13), despite commodity

prices having fallen through 2012.

13. Australias great shock absorber is working again

Source: RBA

To some degree, the AUD was being artificially

held up by capital flowing to Australia in search

of an alternative safe haven to the US bond

market. Since mid-April the AUD has depreciated

and hasmoved back towards commodity pricelevels. Australias shock absorber is once again

working to support the rebalancing of growth in

the economy.

Evidence of rebalancing

Housing market is lifting

A key channel through which low interest ratesare expected to lift the economy is the impact on

new household borrowing. A recent solid rise in

housing loan approvals provides evidence that

monetary policy is getting some traction. The rise

in housing lending is reflected in a lift in activity

in the established housing market. National

housing prices have risen by 5% since their trough

in May 2012 (Chart 14).

14. Housing prices have risen over the past year

Source: RP-Data-Rismark

Housing construction rising

As well as a lift in house prices, housing

construction has also begun to rise from low

levels. Building approvals have picked up since

their trough in early 2012, with annual growth in

building approvals currently sitting at 6% in trend

terms (Chart 15).

15. Housing construction is gradually lifting

Source: ABS

Dwelling investment has the potential to be a key

contributor to growth over the next few years as

a number of factors lend support to the sector (see

Downunder digest: Australias housing pick-up,

19 March 2013). Mortgage rates are at low levels

and the recent rise in house prices will likelyencourage further investment in housing

construction, as development returns rise. In
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addition, we have been through a period of

underinvestment in housing, as construction has

slowed in recent years. Coupled with continued

population growth, demand for new housing is

likely to remain robust (Chart 16).

16. Strong growth in dwelling investment is expected


A rise in dwelling investment will, however, not

be enough. Household consumption also needs to

lift if Australias growth is to rebalance and head

back towards its trend pace.

Rebalancing has been slowerthan expected in some areas

Consumer should revive

Policy should be effective in boosting household

consumption. The cut in policy rates has already

provided a lift to disposable income. With around

90% of households on floating mortgage rates, thedrop in the cash rate has seen required mortgage

payments ease (Chart 17). Higher housing

construction should also see a rise in

consumption, supporting demand for durable

goods to fill new houses. The rise in housing

prices is also helping to lift household wealth, as

around three-fifths of Australian household assets

are the value of houses (seeDownunder digest:

Australias consumer revival, 23 April 2013).

17. Interest paid has fallen, boosting disposable income


However, we have yet to see a significant rise in

household spending. Despite the 200 basis points

in cuts that the RBA has provided, the saving rate

has remained elevated (Chart 18) and

consumption has yet to rise substantially. We still

expect a pick-up in household consumption in

coming quarters, and we have been somewhat

surprised that this has not already occurred.

18. Household saving has remained stubbornly high

Source: ABS

A number of factors may have weighed on

household spending activity. In particular,

conditions in the labour market remain loose,

constraining household sector confidence.

Continued weakness in global activity has also

likely added to household cautiousness (Chart 19).

Households appear to be continuing to repay debts

ahead of required rates, constraining their
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willingness to spend. Continued household

cautiousness is a downside risk to our forecasts.

19. Consumer sentiment dipped, after lifting in early 2013

Source: Thomson Reuters Datastream

Businesses still unhappy

Business confidence has remained subdued,

despite the loosening in financial conditions that

has been delivered recently (Chart 20). Political

developments are likely to be playing a role, with

uncertainty over post-election policies an

election is due before 30 November 2013

complicating the outlook for Australian firms.

20. Business confidence has remained subdued

Source: Thomson Reuters Datastream

Businesses have also held back on hiring recently.

The unemployment rate is currently around 5.5%,

while jobs growth has only averaged around

24,000 a month since the beginning of 2013,

which is not quite enough to match the increase in

the labour force. This has seen the unemployment

rate gradually drift higher since the middle of

2012 (Chart 21). With the unemployment rate

above the full employment level, wage growth has

been subdued, and an elevated unemployment rate

is a factor holding back household confidence.

21. Labour market remains loose, subduing confidence

Source: ABS

Looking forward, policy settings are expected to be

effective in boosting employment. A lower AUD

coupled with lower borrowing costs should see

business confidence begin to improve which

should see firms committing to greater levels of

hiring. After tracking broadly sideways in recentyears, there are already some signs of improvement

in employment in the more exchange rate-sensitive

industries of the Australian economy (Chart 22).

A lower exchange rate should see increased activity

and employment in industries such as tourism, retail

and manufacturing.


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22. Some rebalancing is occurring in the labour market

Source: ABS

Tourism expected to recover

The tourism industry is also expected to recover.

There are some early signs of improvement,

reflecting a strong rise in tourist arrivals from

Asia, particularly China, as the expanding Asian

middle classes can afford to travel abroad and are

coming to Australia (Chart 23). Chinese arrivals

have risen by 85% over the past three years or so.

These trends are expected to continue.

23. Chinese arrivals into Australia are picking up strongly

Source: ABS

The number of Australias departing for

international trips is also expected to level out in

coming months as the lower AUD discourages

international travel (Chart 24).

24. Net outbound flow of tourists is levelling out

Source: ABS

Few structural impediments toprevent rebalancing

Part of our optimism about Australias rebalancing

prospects reflects that we dont think the overall

economy has substantial structural imbalances.

Indeed, inflation and wages have eased in the

broader economy in the past couple of years,

despite the mining boom. There are few signs of

asset price misalignments. In general, there have

been few signs of irrational exuberance in the

Australian economy in recent years.

Importantly, it is therefore only growth that is the

increment of change that has been uneven in recent

years, not the overall level or structure of the

economy. For this reason, it is only growth that

needs to rebalance, not the overall economy. Thissituation makes Australia different to some other

economies that are seeking to rebalance, where the

imbalances are in the structure of their economies.

While some commentators argue that there are

imbalances, we disagree with many of these

arguments. First, in our view, Australia does not

have a housing bubble. Second, while household

debt levels are fairly high, they have been broadly

stable for the past seven years and household debt is

fairly well allocated to households that can afford to

service it. Third, the mining investment that has been


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undertaken is, in our view, an appropriate allocation

of capital, given our outlook for resources demand as

emerging economies continue to drive global

growth. Finally, inflation has been low across the

economy, which is another sign that there have been

limited excesses as a result of the mining boom.

No housing bubble

We have long held the view that Australia does not

have a housing price bubble (seeDownunder digest:

Australian housing outlook positive, 12 July 2012,andAustralias place in the world, 15 March 2011).

While Australian house prices are fairly high, they

are high for structural reasons that reflect

underlying economic fundamentals. These include

that supply is low relative to demand for housing,

partly reflecting urban structure and zoning

restrictions. These constraints limit the quantity of

well located housing in Australian cities and

these supply impediments are only resolved

slowly. Solid population growth and low housing

construction suggest that there is an undersupply

of housing in Australia. A sharp fall in housing

prices would be necessary to establish that

Australia has a housing bubble, and we see a

sharp fall as highly unlikely.

It is worth keeping in mind that while Australian

housing prices are fairly high, they are at

comparable levels to a range of similar

economies. The Australian house price-to-income

ratio is similar to Belgium, the United Kingdom,

New Zealand and Canada, and only a slightly

above the level in Italy and Germany (Chart 25).

25. Australian dwelling prices similar to other countries

Source: RBA

Household debt well allocated

While aggregate household debt is fairly high in

Australia, the key to assessing vulnerability is to

look at the allocation of this household debt. In

Australias case, household debt is well allocated

to households that are likely to be able to continue

to service it. The bulk of debt is held by wealthy

households, with a limited number of highlyindebted and financially vulnerable households.

Around 75% of all household debt is held by the

highest 40% of income earners (Chart 26).

26. Most of the debt is held by wealthy households

Source: RBA

Micro survey data show that Australia also only

has a small proportion of mortgages with very

high loan-to-valuation ratios, high servicing

burdens and low incomes. In 2011, only around

15% of indebted owner-occupiers had a housing

Household Debt by Income Group

0

10

20

30

40

50

Lowest 2 3 4 Highest

%
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gearing ratio greater than 80%. The subset of

households that also had high debt servicing ratios

of greater than 50% of their incomes was low, at

3.5% of all mortgages. Even within this group,

almost half report in surveys that they have built

up some buffer by being ahead on their mortgage

repayments. Australia also never had sub-prime

loans and has a full recourse mortgage system,

which encourages households to only take on

debts they can afford.

Australians have taken the opportunity to

consolidate their balance sheets somewhat in recent

years, with debt-to-income ratios stabilising and

household saving rising (Chart 27). This implies that

the quantity of new and inherently more risky

lending growth has been modest, with households

holding more mature loans and many of them well

ahead on their debt repayments.

27. Household debt has been steady since 2006

Source: ABS, RBA

Mining capital well allocated

During any boom in a sector of an economy, there

are risks of a sharp correction if expectations run

ahead of fundamentals. In our view, however,

rather than a misallocation of resources, the

mining investment boom appears to represent a

rational response to the price signals provided by

the market.

A run-up in the prices of Australias natural

resources saw firms build up productive capacity

in Australia with mining capital allocated based

on the medium-term outlook for resources

demand. As such, rather than an irrational bubble,

the mining investment boom provides both an

initial boost to growth and improves the

medium-term prospects for Australian activity,

through providing a sustained increase in

Australian resources production.

While there have been substantial cost overruns in

many of Australias mining construction projects,

much of this has reflected that Australia has been

trying to do an extraordinary amount of work in a

relatively short period of time. This has meant

demand for skilled labour and capital in the

mining industry has risen well ahead of available

supply and driven up costs. Likewise, as mining

investment is now slowing down, there are

already early signs that many of those costs arefalling. The bottom line remains that Australia is a

low-cost producer of a range of commodities,

even if it has been a high-cost investment

destination in recent years. As we move into the

production phase, Australia is expected to

continue to have an absolute advantage in the

production of most commodities. We discuss this

topic further in the risks chapter, below.

Inflation is lowDespite a mining boom, Australias inflation and

wages growth has been subdued. Overall inflation

is currently at the bottom end of the target band

(Chart 28). Most mining booms in Australias

history saw inflation rise rapidly, leaving

policymakers with less flexibility to respond after

the boom had ended. This time around, inflation is

low, which is also a sign that there have been few

excesses in the broader economy as a result of

this mining boom.


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28. Inflation is in the lower part of the RBAs target range

Source: ABS


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China and Asia

Australias relative success in recent years can be

partly attributed to its strong ties to Asia. Around

70% of Australias exports go to Asia and

commodities constitute the bulk of these exports.

As we set out in the first section, Australias

mining boom has been a key driver of its recent

strong economic performance.

Commodity demand

A sharper downturn in Asia, which sees a fall incommodity demand, is a key downside risk to

Australias outlook. For further discussion of the

risks to the Asian growth outlook see:Asias

bitter medicine, 9 July 2013.

Chinas current slowdown presents some risk in

this regard. In the short run, there is some risk that

Chinas current focus on faster reforms sees less

fixed asset investment than we currently forecast

(see Hongbin Qu, China: Faster reform, slower

growth, 19 June 2013). However, our medium-

term view remains positive. In our view, China

has significant infrastructure yet to build in the

medium term, which should support medium-term

demand for commodities (see Hongbin Qu, China

Inside Out: Yes, China still needs infrastructure,

5 October 2012).

The infrastructure story also extends beyond

China to across the Asian region. Countries where

there is significant infrastructure yet to be built

include India, Indonesia and the Philippines (see

Ronald Man,Bridging the gap, 20 May 2013).

While China is approaching similar levels of per

capita steel consumption as the West, India, for

example, has barely started (Chart 29).

Risks and challenges

Australia is highly dependent on Asia, given that 70% of its

exports go there, which means weaker Asian growth is a key risk

Despite the mining slowdown, we see Australia as unlikely to have

a significant downturn, given our outlook for Asia and because

policymakers have room to move to support growth if needed

The challenge for policymakers is managing the economy in the

wake of the mining boom, which would have been easier if more

had been saved or productivity-enhancing reforms occurred earlier
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29. Steel consumption ramp-up in India is yet to come

Source: RBA

Importantly, much of Australias recent

investment has been in capacity to produce LNG,

and thus energy. Over three-quarters of the

resources investment boom in Australia has been

in capacity to produce LNG. Australia is therefore

set to become a large global energy producer.

The prospects for energy demand are promising,

with a number of Asian developing economies

still at very low levels of per capita energy

consumption. Chinas energy consumption is still

at low levels relative to developed economies and

India is at very low levels (Chart 30). Japan is also

in the process of substituting nuclear power

generation, having shut down 48 of its 50 nuclear

power plants following the March 2011 nuclear

disaster at Fukushima.

30. Energy consumption is still low in China and India

Source: RBA

The LNG outlook is also more stable as all seven

LNG projects currently under construction have

forward sold LNG on long-term contracts to

various Asian nations.

Commodity supply

Another risk for Australia is that the significant

global investment in the resources sector in recent

years leads to a glut of supply, which puts

downward pressure on commodity prices. Our

central view remains that there is only enoughsupply of commodities due to come online to

meet demand at prices that are well above their

1980s and 1990s levels (see Commodities and the

global economy: Are current high prices the new

normal?, 8 August 2012). But there is a risk that

more supply comes online and suppresses prices.

While this is a credible risk, it is important to keep

in mind that Australia is a low-cost producer of a

broad range of commodities. As such, in many

cases Australia would continue to export rising

quantities of commodities, even if the prices were

lower than expected. For iron ore, which is

Australias largest commodity export, the large

producers are very low on the global cost curve

(Chart 31). The same applies for many of the

large coal producers, although not all.

31. Australian iron ore at the low end of the cost curve

Source: AME, HSBC estimates

0

20

40

60

80

100

120140

0 600 1,200 1,800

Cumulative Coste d Production by Company

R

eal(2010)C

ashC

osts

(U

SD

/t)

ValeRio BHP

Chineseproducers
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US shale gas

For LNG, a significant possible threat to supply is

from US shale gas. However, as we noted above,

the LNG story should be more stable than other

commodities as the product is forward sold on

long-term contracts.

Australias domestic economy is also somewhat

protected by the high foreign involvement in the

mining industry. Australias mining sector is

80% foreign-owned and the concentration offoreign involvement in the LNG sector is even

more highly concentrated. Australias seven major

LNG projects are being built by consortia of

global multinationals, including Chevron, Exxon,

Mobil, Shell and Conoco-Phillips. When the

resources boom was ramping up, the leakage of

demand offshore was a source of local angst, as it

meant less support for local demand. Likewise, as

the mining story slows, foreign involvement

should be a source of some comfort, as it has arisk-sharing effect.

Risk of recession is low

Some commentators have started to note that as

the mining investment boom comes to an end, the

risk of a recession in Australia is increasing. Even

the newly appointed Prime Minister Rudd and his

Treasurer Bowen are noting risks of a recession,

which is a significant shift in rhetoric from that of

the previous leadership who were more upbeatabout economic prospects. While a recession can

never be completely ruled out, we remain of the

view that a recession is unlikely in the next couple

of years.

A starting point for making an assessment about

the probability of recession is to look at

Australias history. In the past 52 years, Australia

has had ten years when it was in a technical

recession a period, which begins with two

consecutive quarterly falls in GDP (Chart 32).

Using this historical experience implies that the

probability of a recession in any one year is

around 20% of course this means that there is an

80% chance of no recession in any year.

32. Australia has had six technical recessions in 52 years

Source: ABS, HSBC

Importantly, we dont see the chances of a

recession as significantly higher than normal. To

see a much greater chance than normal means

arguing that there are significant imbalances that

need to correct which, as we have argued above,

we do not see. Or, that there are reasons to think

that policymakers would be unable to respond

effectively to a downturn which also seems

unlikely in Australias case. As we have noted

above, the RBA has room to move on interest

rates if required and the exchange rate could

depreciate further to act as a shock absorber

against negative foreign shocks.

The governments relatively strong balance sheet

also offers a line of defence for the economy. Net

public debt is low, particularly in comparison to

other advanced economies around the world

(Chart 33). At the same time, the government

remains on a path of consolidation and the fiscal

deficit is relatively small (-1.3% of GDP). The

government could provide support for growth

with fiscal stimulus if necessary.


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33. Public debt is very low, so fiscal policy has room to move

Source: IMF

Of course, a recession can never be completely

ruled out. A recession can occur if there is a

significant downside surprise, which happens

quickly and catches policymakers off guard. The

speed of adjustment matters a great deal. This is

one of the reasons why we do not expect the end

of the mining investment boom to cause a

recession because it is widely forecast to occur,

which means markets and policymakers have time

to respond.

The likely driver of a recession would be a

negative surprise from abroad probably a

sharper-than-expected downturn in Asia. Of

course, a downside surprise from abroad would

also motivate a response from overseas

policymakers. In Chinas case, our Chief China

economist remains of the view that China is

highly unlikely to have a hard landing because

Chinese authorities still have plenty of

ammunition to shore up the countrys economy if

needed. In particular, he notes that China has a

fiscal surplus that has totalled RMB960bn in the

first five months, leaving Chinas fiscal accounts

in a healthy position. He sees the risk that GDP

growth falls below 7% as remote (Hongbin Qu,

China Inside Out: Will the cash crunch lead to a

hard landing?, 26 June 2013).

Challenges for policymakersManaging a smooth end to the mining

investment boom is the key challenge facing

Australian policymakers.

This would have been made easier if more had

been done earlier, when commodity prices were

rising. In particular, it is disappointing that

Australias government budget remains in a

structural surplus despite recent years of strong

nominal GDP growth on the back of rising

commodity prices. Policymakers are considered to

have failed to take full advantage of the mining

boom in terms of improving Australias fiscal

position (though, as we noted above, government

debt is still low by global standards).

The kick the economy got from rising commodity

prices has discouraged a hard look by

policymakers at productivity-enhancing reforms.

Indeed, there has been little progress made inproductivity-enhancing reforms, which can be

thought of as another form of saving or

institutional investment. Both of these were key

risks that we were concerned about when asked

whether Australia had a resources curse (Does

Australia have a resources curse? The challenges

of managing a mining boom, 18 August 2011).

For businesses, recent political developments

have also made the tax and regulatory

environment uncertain, which is likely to be a

drag on confidence. The current government has

had a minority in the lower house, which has

limited its capacity to legislate. A recent change

of leadership of the current government and the

forthcoming federal election, which is required to

occur before 30 November 2013, may have added

to local political uncertainty.
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Given low levels of government debt and a fairly

flexible economy, these issues are not expected to

be too detrimental to Australias growth prospects

though it is fair to say Australias does face

some structural issues that should have been dealt

with when incomes were growing strongly.

In the short run, we believe Australias major

economic challenge is a lack of confidence.

Australias great rebalancing relies on businesses

outside of the mining sector and households beingconfident enough to make investments and spend,

and non-mining businesses confident enough to

hire. Despite already low interest rates,

confidence has remained surprisingly subdued in

the first half of 2013. There have been a number

of reasons for this, including the mining

slowdown, worries about growth in China, the

high level the AUD maintained until recently, and

local political issues leading to policy uncertainty.

With limited help from other policymakers, the

central bank is left with the bulk of the burden of

managing the transition from mining investment-led

growth to growth supported by the non-mining

sectors. To manage this, the RBA has already cut its

cash rate to its lowest level in 53 years to support

rebalancing, but until recently the high AUD was

keeping financial conditions tight, despite the

rate cuts.

The recent fall in the AUD will help supportAustralias great rebalancing. The falling AUD is

also an upside risk to inflation, though at this

stage it is largely offset by a loose labour market,

which is continuing to put downward pressure on

local wages growth. The next move in interest

rates is highly dependent on where the AUD

settles. Current market pricing suggests another

cut is likely in coming months.

For other arms of policy, we believe the focus

ought to be on lifting Australias productivity

growth, which has been weak recently. Tax and

regulatory reform ought to be high on the

policymakers agenda and be a key part of the

discussion in the lead-up to this years election.

Infrastructure is also a key issue as congestion is

acting as a key constraint on Australias

productivity growth.

Australias R-wordIn our view, Australias R-word is rebalancing,

not recession.

Given our outlook for the global economy and

Asia in particular, and Australias current policy

settings, a rebalancing of Australias growth is far

more likely than a recession. Asias infrastructure

build-out has many years to run yet and its energy

demand is still low and set to rise rapidly.

We remain cautiously optimistic about our outlook

for the Australian economy for three key reasons.

First, despite a slowdown in Asia, Asian economies

are still expected to be the fastest-growing

economies in the world and Australias strongest

ties are to Asia. Second, Australias mining story is

slowing down, not collapsing, with the ramp-up in

resources exports yet to come. Finally, Australias

interest rates and currency are both now supportive

of a rebalancing of Australias growth; and, in our

view, Australias economy does not have obvious

structural imbalances that constrain its ability for

growth to rebalance.

We expect a period of below-trend growth in

2013, but for growth to head towards trend in

2014. We believe the RBA may need to deliver

further stimulus to support growth, but it is also

possible that the AUD depreciates sufficiently to

obviate the need for further rate cuts.


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Source: ABS, RBA, HSBC forecasts

*unless otherwise specified **includes the effect of the carbon tax from Q312

HSBCs forecasts for Australia

_______ Year-average _______ __________________________Year-ended___________________________2012 2013 2014 Q113 Q213e Q313e Q413e Q114e Q214e Q314e

%*AUSTRALIA

GDP 3.6 2.5 2.8 2.5 2.6 2.5 2.7 2.9 2.9 2.8Consumption 3.3 2.2 2.9 2.0 1.9 2.3 2.6 2.8 2.9 3.0Govt consumption 3.1 0.6 2.1 0.5 -0.5 0.8 1.8 1.8 2.1 2.2Investment 8.7 -0.3 3.0 0.9 1.5 0.6 -2.9 3.8 3.7 2.6- Dwelling -3.8 5.0 9.4 2.7 5.6 5.6 6.1 8.7 10.2 10.3- Business 16.5 -0.2 -0.6 2.3 1.4 -1.6 -2.5 1.6 0.1 -1.8- Public 0.7 -4.3 9.8 -5.8 -2.0 4.2 -11.9 7.2 10.4 11.5Final domestic demand 4.7 1.2 2.8 1.1 0.6 1.3 1.9 2.9 3.0 2.7Domestic demand 4.7 0.7 2.8 0.3 0.4 0.6 1.6 3.0 3.0 2.7Exports 6.0 7.6 6.6 8.1 8.0 8.4 6.1 6.5 6.1 6.7Imports 6.4 -0.3 7.0 -3.2 -1.3 1.0 2.2 7.4 7.0 6.8

GDP (% quarter sa) -- -- -- 0.6 0.7 0.7 0.7 0.8 0.7 0.6

CPI** 1.8 2.4 3.0 2.5 2.7 1.9 2.6 2.9 2.9 3.1Trimmed mean** 2.3 2.3 2.8 2.2 2.2 2.3 2.3 2.6 2.8 2.8

Unemployment rate 5.2 5.5 5.4 5.5 5.5 5.5 5.5 5.4 5.4 5.3Labour price index 3.6 3.2 3.5 3.2 3.0 3.1 3.2 3.3 3.4 3.5

Current A/C (%GDP) -3.9 -2.4 -2.5 -2.2 -2.4 -2.5 -2.4 -2.4 -2.4 -2.6Terms of trade -10.4 -2.9 -0.9 -6.2 -6.1 -0.8 2.1 -0.4 0.0 -1.0Budget balance (%GDP) -3.0 -1.5 -1.0 -- -- -- -- --Capital city house prices -0.7 4.9 5.9 2.6 4.2 6.7 6.2 7.3 6.2 5.2Private sector credit 3.8 3.8 6.6 3.2 3.2 3.9 4.9 6.1 6.8 6.8USD/AUD (end period) 1.04 0.90 0.86 1.04 0.96 0.94 0.90 0.89 0.88 0.8790 day bank bill rate 3.19 2.80 3.30 3.30 3.05 2.80 2.80 2.80 2.80 3.05

Cash rate (end period) 3.00 2.50 3.00 3.00 2.75 2.50 2.50 2.50 2.50 2.75

Forecast table


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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 and Adam Richardson

Important DisclosuresThis document has been prepared and is being distributed by the Research Department of HSBC and is intended solely for the

clients of HSBC and is not for publication to other persons, whether through the press or by other means.

This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer

to buy the securities or other investment products mentioned in it and/or to participate in any trading strategy. Advice in this

document is general and should not be construed as personal advice, given it has been prepared without taking account of the

objectives, financial situation or needs of any particular investor. Accordingly, investors should, before acting on the advice,

consider the appropriateness of the advice, having regard to their objectives, financial situation and needs. If necessary, seek

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Certain investment products mentioned in this document may not be eligible for sale in some states or countries, and they may

not be suitable for all types of investors. Investors should consult with their HSBC representative regarding the suitability of

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The value of and the income produced by the investment products mentioned in this document may fluctuate, so that an

investor may get back less than originally invested. Certain high-volatility investments can be subject to sudden and large falls

in value that could equal or exceed the amount invested. Value and income from investment products may be adversely

affected by exchange rates, interest rates, or other factors. Past performance of a particular investment product is not indicative

of future results.

HSBC and its affiliates will from time to time sell to and buy from customers the securities/instruments (including derivatives)

of companies covered in HSBC Research on a principal or agency basis.

Analysts, economists, and strategists are paid in part by reference to the profitability of HSBC which includes investment

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For disclosures in respect of any company mentioned in this report, please see the most recently published report on that

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* HSBC Legal Entities are listed in the Disclaimer below.

Additional disclosures

1 This report is dated as at 10 July 2013.2 All market data included in this report are dated as at close 09 July 2013, unless otherwise indicated in the report.3 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 Researchoperate and have a management reporting line independent of HSBC's Investment Banking business. Information Barrier

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