Download pdf - 121207 Australia's Great Rebalancing Act - Looking Beyond the Mining Investment Boom

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By Paul Bloxham

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

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

Australias great

rebalancing actLooking beyond the mining investment boom

Macro

Economics Australia

November 2012
https://www.research.hsbc.com/midas/Res/RDV?ao=20&key=LUS0GPE8yW&n=353194.HTM


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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 ofthese 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 thanotherwise (seeDoes 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 spendingpatterns 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.

Key points
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Key points 1Mining story not over yet 3Mining has been the big story 3Not over yet 4Mining story has three stages 4Foreign involvement a cushion 8Growth has been uneven due to mining 8But not that uneven 9High household saving also driving unevenness 9

The great rebalancing act 11Shift back needed 11Housing ripe for recovery, though slow take-off so far 12Retail sector should improve 14Businesses have lowered debt levels 15AUD effect should wear off 16

Resources curse revisited 19Has Australia been cursed? 20If its permanent, its all okay 20High commodities = high AUD? 20The curse of weak productivity growth 21A sharper global slowdown 25

Other risks 25A weaker monetary transmission mechanism 26

Australias fiscal cliff 27A stickier AUD 27Rebalancing smoothly the key challenge 28

Forecast table 29Disclosure appendix 31Disclaimer 32

Contents


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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

Australia's Commodity Prices2008/09 = 100

0

40

80

120

160

1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012

0

40

80

120

160

In AUD

In USD

Index Index

Source: RBA

Commodity prices quadrupled in USD terms

between the beginning of the century and their

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

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

Paul Bloxham

Chief Economist, Australiaand New ZealandHSBC Bank Australia Limited+61 (2) 9255 [email protected]


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steady AUD are expected to result in other parts

of the economy picking up and Australian growth

gradually rebalancing.

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 newnormal?, 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 commodity-

intensive 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).

2. Terms of trade to cycle around new high level

Australia's Terms of Trade

40

60

80

100

1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009 2014

F/CIndex

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 economiccycle 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, commodityprices 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: seeDownunder

digest: Reports of the mining booms death

greatly exaggerated, 26 July 2012.
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First stage is over, as commodity

prices have peaked

While we expect commodity prices to stay high, itis 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).

3. Mining boom not over yet, just part way through stage 2

Source: HSBC


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4. Massive LNG projects still under construction

Estimated spend

Gorgon AUD 43.0Ichthys USD 34.0Wheatstone USD 29.0

Australia Pacific LNG AUD 23.0Queensland Curtis Island LNG USD 20.4Gladstone LNG USD 18.5Prelude AUD 12.0

Source: Australian Treasury

Work yet to be done on mining projects has only

just passed its peak in H1 2012 and is at anextremely 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

5

10

15

20

25

30

35

40

1986 1989 1992 1995 1998 2001 2004 2007 2010

0

5

10

15

20

25

30

35

40

*Per cent of quarterly nominal GDP

Engineering Construction Work

yet to be done*

Mining Investment Pipeline*

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.

6. Mining investment still to contribute to growth next year

GDP growth and mining investmentYear-ended change

-1

0

1

2

3

4

5

2000 2002 2004 2006 2008 2010 2012 2014

%

GDP growth

(y-o-y)

Engineering construction

(contribution to y-o-y)


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.


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Third stage yet to come, as exportsstill 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

-2

0

2

4

6

8

2001 2003 2005 2007 2009 2011 2013

Export volumesAnnual percentage change

% Forecasts


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.

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 OutlookFinancial years

0

300

600

LNG*

Coal

Ironore

LNG*

Coal

Ironore

LNG*

Coal

Ironore

LNG*

Coal

Ironore

LNG*

Coal

Ironore

LNG*

Coal

Ironore

LNG*

Coal

Ironore

LNG*

Coal

Ironore

2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17

0

30

60

MtMt

Forecast

* Righthand side axis

Source: BREE

As we have discussed before, Australias

expansion into LNG production can be thought of

as a great gift (seeDownunder 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 acushion

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 theeconomy 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.

Growth has been uneven dueto 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).

9. Australia was close to full employment until very recently

Unemployment RateSeasonally adjusted

2

4

6

8

10

1978 1982 1986 1990 1994 1998 2002 2006 2010

2

4

6

8

10

% %

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

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

1970 1976 1982 1988 1994 2000 2006 2012

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

AUD/USD

Post-float

average

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

Employment Across IndustriesTrend, February 2007 = 100

100

105

110

2007 2008 2009 2010 2011 2012

100

105

110

Exchange rate sensitive industries*

(33% of total)

Other industries

(67% of total)

* Includes manufacturing, retail trade, acc ommodation and education

Index Index

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.

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).

12. State divergence, though no more than average

Range of unemployment rates across states

0

1

2

3

1978 1982 1986 1990 1994 1998 2002 2006 20100

1

2

3

% %

Averages

Source: ABS

High household saving alsodriving 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

-15

-10

-5

0

5

10

15

20

1 99 3 1 99 5 1 99 7 1 99 9 2 00 1 2 00 3 2 00 5 2 00 7 2 00 9 2 01 1

-15

-10

-5

0

5

10

15

20

Australian household wealth and incomeYear-ended percentage change

% %

Household wealth

Household disposable

income

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

-5

0

5

10

15

20

25

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

-40

0

40

80

120

160

200

Household saving and debtPer cent of household disposable income% %

Debt

(RHS)

Saving

(LHS)

Source: ABS; RBA

This has seen the household debt to income ratio

level out over the past seven years. Householdshave 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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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 run-

up in commodity prices which boosted the terms

of trade. Rising commodity prices boosted

incomes and led to a mining investment boomwhich 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 credit-

driven 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

40

80

120

160

200

240

1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011

0

30

60

90

120

Terms of trade*

(RHS)

*Ratio of export to import prices

Credit to GDP

ratio (LHS)

Commodity price driven growthIndex Index

Source: ABS; RBA

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 non-

performing loans are low at 1.5% of total loans.

Second, the parts of the economy the RBA is

seeking to support are interest-rate sensitivesectors, including housing, retail and consumer

services. Together these sectors constitute a much

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


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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 showsome 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 3Mining 9Manufacturing 8Utilities 2Construction 7Wholesale trade 4

Retail trade 4Transport 5Public administration 5Business services 23- IT 3- Finance and insurance 10- Other 10Household services 15- Health 6- Education 4- Other 5

Other 15

Source: ABS

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 lowlevels. Approvals for housing construction reached

their lowest level in over a decade (Chart 17). With

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 - AustraliaNumber of buildings*

0

5

10

15

1995 1997 1999 2001 2003 2005 2007 2009 2011

0

5

10

15

'000s'000s

Total

Houses

Other*** Thick line represents trend numbers w hile the lighter line represents seasonally adjusted number

** Includes non-residential buldings

Source: ABS

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

-50

-25

0

25

% bps

-400

0

400

800

1986 1989 1992 1995 1998 2001 2004 2007 2010

Building approvals

(year-ended change,LHS)

Cash rate, shifted 12 months

(RHS, inverted scale)

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

Capital city housing prices

400

450

500

550

2006 2007 2008 2009 2010 2011 2012

400

450

500

550

$'000 $'000

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 ofgrowth likely. This is a forecast we first

articulated in July 2012 (seeDownunder 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.

20. House prices expected to rise further given lower rates

Australian housing prices and interest rates

-14

-7

0

7

14

21

2008 2009 2010 2011 2012 2013

4

5

6

7

8

9

Housing prices (six month

annualised growth, LHS)

Mortgage rate

(inverted, six months

advanced, RHS)

% %

Average

mortgage rate

(RHS)

Source: RBA; RP-Data Rismark

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

Housing loan approvals and mortgage rates

12

14

16

18

20

2005 2006 2007 2008 2009 2010 2011 2012

4

5

6

7

8

9

$b %

Mortgage rates

(RHS)

Housing loan

approvals (LHS)

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

0

1

2

3

4

5

6

1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010

0

1

2

3

4

5

6

National rental vacancy rate% %

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 savingmore 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.

23. Household consumption solid, but retail spending weak

Retail Sales and ConsumptionYear-ended growth, nominal

0

2

4

6

8

10

2003 2004 2005 2006 2007 2008 2009 2010 2011 20120

2

4

6

8

10

% %

Retail sales

Consumption

Source: ABS

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 constructioncycle. 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

50

75

100

125

2000 2002 2004 2006 2008 2010 2012

50

75

100

125

Consumer Survey QuestionsLong run average = 100

Consumer

sentiment

Good time to buy a

household item

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).

Businesses have lowereddebt 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

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

-50

-40

-30

-20

-10

0

10

20

30

1989 1992 1995 1998 2001 2004 2007 2010

-50

-40

-30

-20

-10

0

10

20

30Business Conditions

Source: Datastream; National Australia Bank

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

-4

-2

0

2

4

6

2000 2002 2004 2006 2008 2010 2012

-20

-10

0

10

20

30

Business credit growth

Year-ended (RHS)

% %

Monthly (LHS)

Source: RBA

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 corporationsit 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

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

(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

Capital Expenditure SurveyCurrent prices

0

25

50

75

100

125

1989 1993 1997 2001 2005 2009 2013

0

25

50

75

100

125

$bn

Mining

Non-Mining

$bn

Source: ABS

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.

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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November 2012

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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 thatconsumption 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 two-

week 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 tohappen, 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 flowof 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

-5

0

5

10

15

20

25

2005 2006 2007 2008 2009 2010 2011 2012

-30

-20

-10

0

10

20

30

Overseas departures and the exchange rateYear-ended percentage change

% %

AUD trade-weighted

index (RHS)

Overseas

departures (LHS)

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 otherparts 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

80

100

120

140

160

180

200

2007 2008 2009 2010 2011 2012

China (11%)

Overseas Arrivals*

IndexJanuary 2007 = 100

*Share of total in July 2012 in brackets

Other (12%)

Europe (18%)Asia ex China (32%)

US (7%) NZ (20%)

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 currenciesper 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

80

85

90

95

100

105

1990 1993 1996 1999 2002 2005 2008 2011

100

200

300

400

500

600

3.9% 2.9%

Manufacturing indicatorsIndex Q1 1990 = 100

Exports (RHS)

Employment (LHS)

Source: ABS

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 thehigh 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.


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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 strongappreciation 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 ifpermanentdamage 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 andbusinesses lack impetus to reform and improve

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


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the efficiency of the economy, leaving the

economy with weak productivity growth.

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

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.

High commodities = highAUD?

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 and33). 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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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 mostof the post-War period.

The curse of weakproductivity 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 policymakersand 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

32. Has the currency really been that high, or is it back to a more normal long-run historical level?

0.00

0.50

1.00

1.50

2.00

2.50

3.00

1901 1908 1916 1923 1931 1938 1946 1953 1961 1968 1976 1983 1991 1998 2006

0.00

0.50

1.00

1.50

2.00

2.50

3.00

USD per AUD

Float

Nominal Exchange Rate

UK pound per AUD

Source: RBA

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 TrendsAverage for 1860-2010=100

80

90

100

110

1865 1875 1885 1895 1905 1915 1925 1935 1945 1955 1965 1975 1985 1995 2005

80

90

100

110

IndexIndex

* Excludes oil

Source: Erten and OCampo (2012)


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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 economyand the structural change that is occurring,

particularly developments in the mining and

utilities industries.

34. Productivity growth has been weak

GDP per hour worked*Index (log scale)

4.60

4.70

4.80

4.90

5.00

5.10

5.20

1980 1984 1988 1992 1996 2000 2004 2008 2012

100

110

130

190

1980-85

1.6%pa

1985-90

0.9%pa

1990-95

1.7%pa

1995-00

2.6%pa

2000-05

1.9%pa

2005-11

1.2%pa

Source: ABS

Is it the curse of lack of reform?

Possible drivers of weak productivity growth

include: limited reform of the tax system; a labourmarket 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.

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 _______________1973/74-1993/94

1993/94-2003/04

2003/04-2010/11

Selected market sector industriesLabour productivity 1.8 3.1 1.4

of which:Capital deepening 1.3 1.3 1.8Multifactorproductivity

0.6 1.8 -0.4

Excluding mining and utilitiesLabour productivity - 3.1 1.7

of which:Capital deepening - 1.3 1.3Multifactor productivity - 1.9 0.4

Source: RBA

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.

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.

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).

36. Underlying inflation may have passed its trough

Measures of Underlying InflationYear-ended change

0

1

2

3

4

5

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 20120

1

2

3

4

5Weighted median

Trimmed mean

CPI

(excl vol items)

% %

Source: ABS; RBA

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

Components of InflationYear-ended change

-4

-2

0

2

4

6

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

-4

-2

0

2

4

6

Non-tradeables

(domestic)

Tradeables(mostly imported)

% %

Source: ABS; RBA

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 innon-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, thesustainable 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

Labour Price Index GrowthSeasonally adjusted

0

1

2

3

4

1999 2001 2003 2005 2007 2009 2011

0

1

2

3

4

Year-ended

Quarterly

% %

Six month

annualised

Source: ABS

Our own estimates suggest that if productivity is

not lifted, then the sustainable pace of growth in

the Australian economy could be around 2.50-

2.75%, 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).
https://www.research.hsbc.com/midas/Res/RDV?p=pdf&$sessionid$=WYOumZqBTC9vj2rwbH1XdIn&key=3ZuwlV0GbV&n=322588.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&$sessionid$=WYOumZqBTC9vj2rwbH1XdIn&key=3ZuwlV0GbV&n=322588.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&$sessionid$=WYOumZqBTC9vj2rwbH1XdIn&key=3ZuwlV0GbV&n=322588.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&$sessionid$=WYOumZqBTC9vj2rwbH1XdIn&key=3ZuwlV0GbV&n=322588.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&$sessionid$=WYOumZqBTC9vj2rwbH1XdIn&key=3ZuwlV0GbV&n=322588.PDF


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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 theslowdown 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). Thisreflects 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.

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


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39. Australias economy now highly reliant on China

Real GDP Growth in China and AustraliaYear-ended change

0

4

8

12

1996 1998 2000 2002 2004 2006 2008 2010 20120

2

4

6

% %

China (LHS)

Australia (RHS)

Source: Datastream

A weaker monetarytransmission 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 couldmitigate 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

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 otherdeveloped 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

-25

-20

-15

-10

-5

0

5

10

15

20

1963 1968 1973 1978 1983 1988 1993 1998 2003 2008 2013

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

40.0

Household Saving%

%

Change in saving rate*

Level of saving rate

*Three-year rolling change

Source: ABS

Recent surveys of consumer sentiment provide

some hope that households are becoming a bit

more positive about their finances, aftersignificantly less confidence for most of the past

few years (Chart 41).


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41. Lower rates are having some effect on confidence

60

70

80

90

100

110

120

130

140

2000 2002 2004 2006 2008 2010 201260

70

80

90

100

110

120

130

140

Personal financial position over coming year

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.

42. Government committed to get back to surplus this year

Federal Government Budget BalancePer cent of nominal GDP

-5

-4

-3

-2

-1

0

1

2

%

-5

-4

-3

-2

-1

0

1

2

%

Jun 90 Jun 93 Jun 96 Jun 99 Jun 02 Jun 05 Jun 08 Jun 11 Jun 14

MYEFO

Oct' 12

Budget

May'12

Forecast

Historical

Source: Federal Treasury

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

80

90

100

110

120

130

140

150

1984 1987 1990 1993 1996 1999 2002 2005 2008 201160

80

100

120

140

160

180

200

Real Exchange Rate on

TWI-basis (LHS)

Terms of Trade

(RHS)

Real Exchange Rate and Terms of TradePost-float average = 100

Source: ABS; RBA

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 keychallenge

We remain optimistic that the economy will be

able to rebalance in 2013-14, while maintaining

around trend growth.

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 thi