Economic Overview (NER 60)

National Economic Review

National Institute of Economic and Industry Research

No. 60               December 2006

The National Economic Review is published four times each year under the auspices of the Institute’s Academic Board.

The Review contains articles on economic and social issues relevant to Australia. While the Institute endeavours to provide reliable forecasts and believes material published in the Review is accurate it will not be liable for any claim by any party acting on such information.

Editor: Dr A. Scott Lowson

© National Institute of Economic and Industry Research

This journal is subject to copyright. Apart from such purposes as study, research, criticism or review as provided by the Copyright Act no part may be reproduced without the consent in writing of the Institute.

ISSN 0813-9474

Economic overview

Peter Brain, Executive Director, NIEIR

Abstract

In this article Peter Brain assesses the medium term outlook for both the world and Australian economies, including the importance for the latter of public sector demand and immigration as important drivers of growth.

An overview of the medium term outlook for the world and Australian economies

The medium-term outlook for the Australian economy remains shaped by a number of conflicting influences.

On the positive side these include:

  • the strong terms of trade gains which will exert upward pressure on growth, particularly in States such as Western Australia and Queensland.
  • a steady outlook for immigration; and
  • the fact that public sector balance sheets in Australia are very strong.

On the negative side are:

  • the strong downward pressure on discretionary consumption expenditure from the weight of household debt;
  • increased import penetration of final and intermediate manufactured goods, particularly from China, leading to manufacturing closures, namely in New South Wales, Victoria and South Australia; and
  • the current downturn in new dwelling construction, concentrated in 2005-06.

The strong terms of trade gains made over recent years – shown in Figure 5 – are expected to exert strong upward pressure on Australian GDP growth over the next two years. The resource boom will bring higher levels of private business investment, infrastructure development and a higher exchange rate that would have otherwise have been case. This will support higher income growth. Actual expenditures will be concentrated in the resource rich states of Queensland and Western Australia. The developing imbalance in the world economy (US trade and budget deficits, China’s increasing share of world production) will produce a correction by 2009. The question is, how severe this correction will be. A sharp correction has not been factored into this forecast, however, world growth is forecast to weaken in 2009 and 2010, and the terms of trade to fall back significantly.

Whilst the contribution of the household sector to growth will be limited by debt constraint, the state of public sector balance sheets in Australia can increasingly drive growth. The public sector can drive growth by income tax changes, infrastructure spending (which is already occurring in some states) and also debt leverage through public sector partnerships and co-opting the superannuation sector, through their infrastructure funds, to play a direct role in driving growth.

Whilst the increase in the terms of trade will benefit the resource based sectors of the Australian economy, the higher exchange rate and increasing competition from imports have, and will continue to, lead to a downsizing of Australia’s established manufacturing sectors.

The import penetration has been steadily rising in Australia, both in terms of final manufacturing products and intermediate inputs. More and more Australian manufacturers are either shifting their operations overseas or stopping operations and importing products from overseas. Australian established manufacturers in older urban area have also seen a dramatic increase in their land values as a result of the housing boom. The profitability of these operations, under increased import competition, has narrowed against the actual income potential of the land they occupy. The high exchange rate has also blunted Australia’s manufacturing export potential.

Capture1As we have seen over the recent years in Australia, the gains by the commodity based sectors of the economy and the resource based sectors will be partly offset by the downsizing and closure of established manufacturing operations. The established manufacturing sectors are concentrated in New South Wales, Victoria and South Australia.

International outlook

The world economy continued to expand at a rapid pace in 2004 with continued strong growth in the United States, China and East Asia. Economic growth in the Western Europe and Japan also picked up significantly in 2004. World economic growth was around 5 percent in 2004. This follows growth of 4 per cent in 2003 and 3 per cent in 2002. China’s GDP growth rate was around 10 per cent in 2003 and 2004.

In the projections, growth in the Chinese economy is expected to continue at around 8 to 10 per cent level through to 2009. Growth is expected to fall following the Beijing Olympics. Australian commodity exports and prices are expected to weaken at this point, with Australian terms of trade and the exchange rate both falling.

The world economy appears to have passed its cyclical peak growth rate. World economic growth is forecast to weaken slightly over 2005 -06 and 2006-07, partly in response to high oil prices. Growth is still however between 3.5 and 4.0 per cent.

The United States economy, which grew by 4.4 per cent in 2004, is projected to grow by 3.5 per cent in 2005 and 3 per cent in 2006. With continued pressures on US public sector balance sheets, high household and corporate debt levels, growth in the US economy us expected to slow post 2006. The US current account deficit reached around 6.5 per cent of GDP in early 2005. The Federal Reserve has been successively increasing rates since mid-2004, and further rates rises seem likely.

Growth in Japan was 2.7 per cent in 2004 following growth of 1.4 per cent in 2003. Growth in 2005 is projected to be 1.4 per cent and 1.8 per cent in 2006. The fundamental of the Japanese economy definitely improved over the last 18 months, and even the banking sector balance sheets have improved.

World economic growth slows to 3.5 per cent in 2008-09 and then 2.7 per cent in 2009-10, mainly reflecting weaker US economic growth and growth in China contracting to around half current growth rates.

The recent drivers of Australian economic growth

The drivers of Australia’s economic growth over the last decade are now going into reverse. From Figure 2, the household debt service ratio reaches 28 per cent of net disposable income in 2004-05. The debt service ratio is the ratio of interest and repayment of loans to net household income. This is now considerably higher than the peak level that prevailed before the 1991 recession.

In the March quarter 2005, the Australian household debt to disposable income ratio reached 174 per cent as shown in Figure 4. By comparison, the ratio four years earlier in March 2001 stood at 123 per cent. This rate of increase cannot be sustained. Indeed, this rate of increase in the household debt to income ratio is declining, as indicated by Figure 3.

It is not only debt saturation that is leading to a decline in households’ ability to absorb debt. As Figure 3 indicates, there has been a decline in the household net worth to income ratio over the last four quarters, compared to the peak level in March 2004. Household net worth is household financial assets plus market value of housing stock less financial liabilities. The major reason for the decline/stabilisation has been the stabilisation of house prices in the context of further growth in household debt.

The deteriorating household balance sheets are being reflected in the current sluggish growth in retail sales and the current slower growth in household consumption expenditure. As a result, household consumption expenditure is forecast to slow to 2.9 per cent in 2005-06 and remain at between 2.5 and 3.0 per cent per annum till the end of the decade.

Capture2In the May 2005 Budget the Federal Government gave personal income tax cuts equal to 1.0 percentage point of household income. The commencement of severe downward pressure on household expenditures from debt saturation and falling net worth to income ratios (from expected falls in house prices over 2005-06) will either offset the impact of the expenditure enhancing effects of the tax cuts, or will force the additional income from the tax cuts to be saved.Capture4
Capture3The Australian medium-term outlook

Australian GDP growth over 2004-05 was 2.3 per cent, the lowest since 2000- 01. The slowdown in Australian growth over 2004-05 reflects a gradual slowing in private consumption expenditure growth and a small fall in new dwelling investment. Household consumption expenditure and new dwelling investment were drivers of Australia GDP growth over the 2001-02 to 2003-04 peri

High levels of consumption expenditure and rising levels of business investment have lead to sharp increases in imports over the last 3 years. Import growth over the 2002 -03 to 2004-05 period has been averaging around 12 per cent per annum. Imports significantly subtracted from growth in 2004-05.

Australian GDP growth is forecast to accelerate to 2.9 per cent in 2005-06 and 3.5 per cent in 2006-07. Private consumption expenditure and dwelling construction, however, will not be the key drivers of growth. Dwelling approvals have already fallen and private dwelling construction expenditure is expected to fall by 10 per cent in 2005-06. The decline could be more significant depending upon the rate of adjustment by builders in this sector.

The decline in private consumption expenditure growth over the course of 2004-05 confirms the household debt constraint is increasing taking hold. The Federal Government tax cuts announced in 2005 will mostly be absorbed by increases in the household savings ratio. Consumption expenditure growth will fall below that ratio of growth in real household disposable income.

For the next two years Australia’s export performance will be relatively strong.

Australia’s export performance will improve over the next two years. Average export volume growth is expected to be in the vicinity of 5.0 to 6.0 per cent per annum. Export volumes are also expected to be reasonably strong as resource projects commencing over the next year are completed.

The restructuring of the manufacturing sector is adversely affecting exports. As import penetration steadily increases and plants close, exports fall because many of these bigger plants also export. Between 2008 and 2011, given the world outlook, Australia’s export performance looks bleak, unless a significant devaluation occurs.

The Australian dollar is likely to devalue strongly after 2007 or 2008.

Given Australia’s current high terms of trade from the high commodity prices and the likely downward pressure on the US$ over the next one to two years, Australia’s currency, in US$ terms, could well appreciate to the 80 cents range. This will not last. The slowdown in world GDP growth post 2008 will return the Australian current account deficit, as a per cent of GDP, to the 7.0 per cent benchmark. The return of commodity growth to more normal levels will combine with these factors to drive the Australian currency to the 60 to 70 cents range, against the US$. Given the expected devaluation of the US$, this implies a significant weighted average devaluation of the Australian currency. This is 25 per cent by 2010. The weighted average exchange rate returns to close to the low levels of 2001.

Capture6Public sector demand will become a more important driver of Australian growth.

The 2005 round of Government budgets is the forerunner of what is to come. That is, Governments in Australia sustaining growth by using their strong balance sheets to offset the decline in the capacity of the household sector to sustain growth. The State Government’s 2005-06 infrastructure expansion will add 0.5 per cent per annum to Australia’s growth rate over the next two years.

More importantly, Governments are beginning to think long term. The Queensland Government has announced a $55 billion expenditure program, while the New South Wales program is around $20 billion. Over the next 20 years, depending on the PPP (private-public sector partnership) component, Australian Governments could spend between $700 billion and $1 trillion dollars and still maintain acceptable debt to GDP ratios.

The Government sector will take over the role from the household sector in driving total investment.

 Immigration will also become an important driver of growth.

The Federal Government has announced that permanent and long term immigration will be increased by 20,000 to offset Australia’s skill shortages. Over the projection period, immigration will become an important source of growth from a variety of linkages. These include:

  • workplace growth to offset the ageing of the population;
  • direct capital inflows associated with wealthy immigration; and
  • network integration with Asia to sustain Australia’s export performance.

The next movement in interest rates will be downwards.

The downturn in the dwelling cycle has commenced. In the Eastern States the level of approvals are 10 to 20 per cent below the levels that prevailed a year ago. Domestic demand growth is slowing. Interest rates are likely to be lowered at some point in 2006. However, the extent of the downward adjustment is likely to be limited. Inflationary pressures (currently from skill shortages and commodity prices) will be joined by currency devaluation post 2008.

This will keep nominal wages and inflation at near the upper bound of the Reserve Bank of Australia’s (RBA) acceptable range for much of the projection period, despite periods of weak labour market conditions. This will also occur despite downward pressure on low skilled wage rates that will flow from the Federal Government’s industrial relations reforms.

Overall, the outlook over the projection period is one described by the RBA Governor last year. It is a growth outlook for annual Australian GDP growth that “will sometimes have a 2 in front of it and sometimes a 3”.

Capture6 Energy trade

Despite rapidly rising oil prices, rising crude oil and product imports and static domestic crude oil and condensate production, net exports of energy continue to rise. Energy exports are expected to be strong post-2006, mainly due to large expected increases in LNG exports.

Capture7

Economic Overview (NER 58)

National Economic Review  National Institute of Economic and Industry Research   No. 58        September 2005

The National Economic Review is published four times each year under the auspices of the Institute’s  Academic Board.  The Review contains articles on economic and social issues relevant to Australia. While the Institute endeavours to provide reliable forecasts and believes material published in the Review is accurate it will not be liable for any claim by any party acting on such information.

Editor: Dr A. Scott Lowson National Institute of Economic and Industry  Research 

This journal is subject to copyright. Apart from such purposes as study, research, criticism or review as provided by the Copyright Act no part may be reproduced without the consent in writing of the Institute.

 

Economic overview  Peter Brain, Executive Director, NIEIR 

Abstract : Peter Brain assesses the Australian economy and describes alternative scenarios.

Although the GDP growth for 2003-04 was 3.6 per cent, this represented a relatively poor performance.  The GDP growth rate of 3.6 per cent for 2003-04 was the same as earlier projections. However, it represented a relatively poor performance. The reason for this assessment is due to the fact that over 2003-04 the Australian farm sector recovered from the drought. Farm product in 2003-04 grew by 27 per cent, adding 0.7 per cent to GDP growth. However, non-farm GDP grew by 3 per cent for 2003-04 despite a 5.6 per cent private consumption growth which represents the highest rate of growth for a number of years. Moreover, the growth rate of all the private investment components was 6 per cent or greater.  The reason for the relatively poor GDP growth outcome is, firstly, the poor performance of exports and, secondly, the growth in imports. There is a lag between farm production recovery and exports so the growth in exports resulting from the farm recovery will occur in 2004-05.  In 2003-04 imports grew by 13.1 per cent, only slightly below the growth in 2002-03. This represents a growth in import penetration across a wide range of sectors, including clothing, textiles, motor vehicles, chemicals and machinery. Imports represent one quarter of GDP. Hence, a 13.1 per cent import growth rate means that the growth in imports over 2003-04 reduce GDP by 2.5 per cent from what would otherwise have been the case if imports had growth in line with GDP.  Over the last two years in particular, the growth in imports has been a major negative factor in determining  Australia’s growth performance.

Australia’s exports performance has also been poor but will recover over the next three years.

In the few years since 1999-00, the value of Australia’s non-resource based exports has been flat. That is, no change has occurred. This is despite the value of trade in the Asia-Pacific region for non-resource based products growing between 30 and 40 per cent over the past four years.  In 2004-05 exports of goods and services are expected to grow by 5.1 per cent, in part due to the recovery of the farm sector. Exports will also recover over the next two to three years because of the coming on-line of major resource projects that were commenced in 2002 or 2003. The most important of these will be the fourth liquefied natural gas (LNG) train on the North West Shelf. In 2006 the Darwin LNG train will come on-line.

Both the United States and Australian dollars will devalue over the next five years relative to our trading partners. 

Exports may well recover, but without a substantial devaluation of the Australian dollar, import growth will continue to outstrip the growth of exports. With the upswing in the world interest rate cycle now occurring, the continuation of the current growth in imports would lead to an Australian current account deficit of around 7 per cent of GDP. To hold the current account deficit at the 5 per cent level, which is the projection to 2008-09, it is necessary for the Australian dollar to devalue,  in weighted average terms of around 15 per cent over the 2006 to 2009 period. This is built into the projection.  It can be seen from Table 1 that the United States/Australian exchange rate stays relatively unchanged over the projection period. The projection also allows for the outcome that the United States dollar devalues 20 per cent against the Euro, yen and yuan over the projection period. Because Australia maintains parity with the United States dollar, it follows that there is an equivalent devaluation of the Australian dollar against these currencies. The appreciation of the yuan against the United States dollar is also assumed to trigger the appreciation of other Asian currencies against the United States dollar.  It is the devaluation of the Australian dollar that leads to a more subdued growth rate for imports over 2008 and 2009.

The recent evidence is that the downside phase of the dwelling cycle has commenced.

It has long been NIEIR’s contention that the down-phase of the current dwelling cycle would only commence when significant growth in established house prices ceased. By the June quarter 2004, established house prices had stabilised with a fall in established house prices in Sydney offset by more moderate price growth elsewhere. Moreover, the trend in approvals and the financing of dwellings for new construction all point to falls in dwelling construction over the next two years. Over the next two years the cumulative decline in housing construction is projected to be 18 per cent.

The borrow and spend behaviour of households is now reaching its peak. Household balance sheet constraints will be a negative factor for growth for the foreseeable future. 

The ending of the established house price boom will also lead to a curtailment of a key driver of recent Australian economic growth, namely household borrowing to support consumption expenditure.

The growth in established house prices since 1996 resulted in the ratio of household net worth (the value of the housing stock plus financial assets less financial liabilities) increasing from 6 to 7.8 by June 2005 (Figure 2). From Figure 4, this allowed households to borrow to fund a borrowing gap which has reached 15 per cent of disposable income by June quarter 2004. The borrowing gap represents the difference between consumption expenditure and discretionary income. Discretionary income is significantly smaller than household income in the national accounts because it includes superannuation contributions and superannuation interest, which represents income that is not available for current consumption.  From Figure 3, by the June quarter 2004 the build up in debt to fund the borrowing gap (as well as the high level of housing investment) drove the household debt to net disposable income ratio to 163 per cent. In the June quarter 2002 the rate stood at 137 per cent.  From Figure 1, the household debt service ratio now stands at 25 per cent of disposable income, the highest on the historical record.  The combined impact of stable (or falling) house prices, high debt service and debt-income ratios will, at the most optimistic, force households to hold the borrowing gap at around 15 per cent of income. This will force consumption expenditure to grow in line with household disposable income, which in turn will reduce the rate of growth of private consumption expenditure to between 2 and 3 per cent over the medium term.

Even with modest consumption growth, the debt-income/debt-service ratio will continue to rise. A recession is likely at some point before 2010.

If the borrowing gap is held at 15 per cent, the debt-income ratio will still increase by around 7 percentage points per year. By 2009, given the projection in Table 1, the debt to income ratio will reach 200 per cent. If households decide to stabilise their debt-income ratio then the household savings ratio will have to rise to 6 to 8 per cent. Household consumption would most likely fall and the economy would experience a recession, probably a severe recession. However, given the forecast methodology outlined above, this aspect has been translated into a lower trend rate of growth rather than a recession and this aspect makes the low case projection of more interest than the high case projection.

Fiscal stimulus will support the household sector in the short term.  

The position in the short term is not as bleak as the borrowing gap would suggest because of the strong fiscal stimulus being given to the economy. The May 2004 Federal Budget and the election promises of October 2004 will give a stimulus of around 1 per cent per annum to household income over the next two to three years. This will probably be enough to partially offset the constraints of the household debt-service ratio. Beyond 2007, if a severe recession is to be avoided, further significant fiscal stimulus will be required. That is, as the growth in household debt slows, public sector new borrowings will have to increase significantly.

The alternative scenarios

The problem for Australia is that Australia is not the only economy with households with large amounts of illusionary wealth created by housing price bubbles. The same is true in North America, the United Kingdom and some Western European economies. An economy that is an indicator, in terms of a low scenario over the medium term, is the Netherlands. The Netherlands was a fast growing economy over the second half of the 1990s, in part driven by rapid increases in borrowings funding a house prices-wealth creation consumption boom. In 2001, house prices stabilised due to tightening monetary policy. In 2003 the economy was in recession with private consumption falling by 1.5 per cent, the largest fall since World War II.  For the Netherlands the catalyst was tightening European monetary policy over 2000. For Australia the likely trigger for a low scenario is also most likely to be an external shock such as illustrated in Table 2. There are a number of potential shocks with good probabilities of occurring over the next two to five years. They are listed in the Table.

The reason why a transition path from the base to low scenario is likely to be associated with an external catalyst is that there are two factors that would allow policy authorities to keep the economy on the base scenario trajectory despite increasing constraints in growth. These are:

  1. strong public sector balance sheets which would allow fiscal policy to be expansionary for a decade or more;
  2. the potential for Australian nominal interest rates to be lowered by between 1 and 2 percentage points.

This cushion would allow the base scenario to be achieved if the world economy remained supportive.  Unfortunately, because of vulnerable households in a number of major economies, any negative shock to the world economy is likely to trigger the ushering in of a long period of low growth for Australia, in particular, and many parts of the developed world in general. In short, the low scenario, at least to 2012 or thereabouts, does not have a low probability of outcome.  The high scenario assumes the most optimistic outcomes for the world political economy.

Australian energy trade, 2004-10 

ABARE and NIEIR analysis and estimates of Australian energy trade trends are presented below. Over the period there continues to be an energy trade surplus with projected increases in net oil imports being more than offset by coal, natural gas and uranium export increases.  In 2004-05 the trade surplus, at a projected $7.4 billion (NIEIR/ABARE), will be about $2 billion higher than in 2003-04 due to higher thermal coal exports (tonnes, prices) and higher LNG exports.

Capture1

Capture2

Capture3 Capture4

 

Economic Overview (NER 58)

National Economic Review No. 58 September 2005

The National Economic Review is published four times each year under the auspices of the Institute’s

Academic Board.

The Review contains articles on economic and social issues relevant to Australia. While the Institute endeavours to provide reliable forecasts and believes material published in the Review is accurate it will not be liable for any claim by any party acting on such information.

Editor: Dr A. Scott Lowson

National Institute of Economic and Industry Research

This journal is subject to copyright. Apart from such purposes as study, research, criticism or review as provided by the Copyright Act no part may be reproduced without the consent in writing of the Institute.

ISSN 0813-9474

Economic overview

Peter Brain, Executive Director, NIEIR

Abstract

Peter Brain assesses the Australian economy and describes alternative scenarios

Although the GDP growth for 2003-04 was 3.6 per cent, this represented a relatively poor performance.

The GDP growth rate of 3.6 per cent for 2003-04 was the same as earlier projections. However, it represented a relatively poor performance. The reason for this assessment is due to the fact that over 2003-04 the Australian farm sector recovered from the drought. Farm product in 2003-04 grew by 27 per cent, adding 0.7 per cent to GDP growth. However, non-farm GDP grew by 3 per cent for 2003-04 despite a 5.6 per cent private consumption growth which represents the highest rate of growth for a number of years. Moreover, the growth rate of all the private investment components was 6 per cent or greater.

The reason for the relatively poor GDP growth outcome is, firstly, the poor performance of exports and, secondly, the growth in imports. There is a lag between farm production recovery and exports so the growth in exports resulting from the farm recovery will occur in 2004-05.

In 2003-04 imports grew by 13.1 per cent, only slightly below the growth in 2002-03. This represents a growth in import penetration across a wide range of sectors, including clothing, textiles, motor vehicles, chemicals and machinery. Imports represent one quarter of GDP. Hence, a 13.1 per cent import growth rate means that the growth in imports over 2003-04 reduce GDP by 2.5 per cent from what would otherwise have been the case if imports had growth in line with GDP.

Over the last two years in particular, the growth in imports has been a major negative factor in determining

Australia’s growth performance.

Australia’s exports performance has also been poor but will recover over the next three years.

In the few years since 1999-00, the value of Australia’s non-resource based exports has been flat. That is, no change has occurred. This is despite the value of trade in the Asia-Pacific region for non-resource based products growing between 30 and 40 per cent over the past four years.

In 2004-05 exports of goods and services are expected to grow by 5.1 per cent, in part due to the recovery of the farm sector. Exports will also recover over the next two to three years because of the coming on-line of major resource projects that were commenced in 2002 or 2003. The most important of these will be the fourth liquefied natural gas (LNG) train on the North West Shelf. In 2006 the Darwin LNG train will come on-line.

Both the United States and Australian dollars will devalue over the next five years relative to our trading partners.

Exports may well recover, but without a substantial devaluation of the Australian dollar, import growth will continue to outstrip the growth of exports. With the upswing in the world interest rate cycle now occurring, the continuation of the current growth in imports would lead to an Australian current account deficit of around 7 per cent of GDP. To hold the current account deficit at the 5 per cent level, which is the projection to 2008-09, it is necessary for the Australian dollar to devalue,

in weighted average terms of around 15 per cent over the 2006 to 2009 period. This is built into the projection.

It can be seen from Table 1 that the United States/Australian exchange rate stays relatively unchanged over the projection period. The projection also allows for the outcome that the United States dollar devalues 20 per cent against the Euro, yen and yuan over the projection period. Because Australia maintains parity with the United States dollar, it follows that there is an equivalent devaluation of the Australian dollar against these currencies. The appreciation of the yuan against the United States dollar is also assumed to trigger the appreciation of other Asian currencies against the United States dollar.

It is the devaluation of the Australian dollar that leads to a more subdued growth rate for imports over 2008 and 2009.

The recent evidence is that the downside phase of the dwelling cycle has commenced.

It has long been NIEIR’s contention that the down-phase of the current dwelling cycle would only commence when significant growth in established house prices ceased. By the June quarter 2004, established house prices had stabilised with a fall in established house prices in Sydney offset by more moderate price growth elsewhere. Moreover, the trend in approvals and the financing of dwellings for new construction all point to falls in dwelling construction over the next two years. Over the next two years the cumulative decline in housing construction is projected to be 18 per cent.

The borrow and spend behaviour of households is now reaching its peak. Household balance sheet constraints will be a negative factor for growth for the foreseeable future.

The ending of the established house price boom will also lead to a curtailment of a key driver of recent Australian economic growth, namely household borrowing to support consumption expenditure.

The growth in established house prices since 1996 resulted in the ratio of household net worth (the value of the housing stock plus financial assets less financial liabilities) increasing from 6 to 7.8 by June 2005 (Figure 2). From Figure 4, this allowed households to borrow to fund a borrowing gap which has reached 15 per cent of disposable income by June quarter 2004. The borrowing gap represents the difference between consumption expenditure and discretionary income. Discretionary income is significantly smaller than household income in the national accounts because it includes superannuation contributions and superannuation interest, which represents income that is not available for current consumption.

From Figure 3, by the June quarter 2004 the build up in debt to fund the borrowing gap (as well as the high level of housing investment) drove the household debt to net disposable income ratio to 163 per cent. In the June quarter 2002 the rate stood at 137 per cent.

From Figure 1, the household debt service ratio now stands at 25 per cent of disposable income, the highest on the historical record.

The combined impact of stable (or falling) house prices, high debt service and debt-income ratios will, at the most optimistic, force households to hold the borrowing gap at around 15 per cent of income. This will force consumption expenditure to grow in line with household disposable income, which in turn will reduce the rate of growth of private consumption expenditure to between 2 and 3 per cent over the medium term.

Even with modest consumption growth, the debt-income/debt-service ratio will continue to rise. A recession is likely at some point before 2010.

If the borrowing gap is held at 15 per cent, the debt-income ratio will still increase by around 7 percentage points per year. By 2009, given the projection in Table 1, the debt to income ratio will reach 200 per cent. If households decide to stabilise their debt-income ratio then the household savings ratio will have to rise to 6 to 8 per cent. Household consumption would most likely fall and the economy would experience a recession, probably a severe recession.

However, given the forecast methodology outlined above, this aspect has been translated into a lower trend rate of growth rather than a recession and this aspect makes the low case projection of more interest than the high case projection.

Fiscal stimulus will support the household sector in the short term.

The position in the short term is not as bleak as the borrowing gap would suggest because of the strong fiscal stimulus being given to the economy. The May 2004 Federal Budget and the election promises of October 2004 will give a stimulus of around 1 per cent per annum to household income over the next two to three years. This will probably be enough to partially offset the constraints of the household debt-service ratio. Beyond 2007, if a severe recession is to be avoided, further significant fiscal stimulus will be required. That is, as the growth in household debt slows, public sector new borrowings will have to increase significantly.

The alternative scenarios

The problem for Australia is that Australia is not the only economy with households with large amounts of illusionary wealth created by housing price bubbles. The same is true in North America, the United Kingdom and some Western European economies. An economy that is an indicator, in terms of a low scenario over the medium term, is the Netherlands. The Netherlands was a fast growing economy over the second half of the 1990s, in part driven by rapid increases in borrowings funding a house prices-wealth creation consumption boom. In 2001, house prices stabilised due to tightening monetary policy. In 2003 the economy was in recession with private consumption falling by 1.5 per cent, the largest fall since World War II.

For the Netherlands the catalyst was tightening European monetary policy over 2000. For Australia the likely trigger for a low scenario is also most likely to be an external shock such as illustrated in Table 2. There are a number of potential shocks with good probabilities of occurring over the next two to five years. They are listed in the Table.

The reason why a transition path from the base to low scenario is likely to be associated with an external catalyst is that there are two factors that would allow policy authorities to keep the economy on the base scenario trajectory despite increasing constraints in growth. These are:

  • strong public sector balance sheets which would allow fiscal policy to be expansionary for a decade or more; and
  • the potential for Australian nominal interest rates to be lowered by between 1 and 2 percentage points.

This cushion would allow the base scenario to be achieved if the world economy remained supportive.

Unfortunately, because of vulnerable households in a number of major economies, any negative shock to the world economy is likely to trigger the ushering in of a long period of low growth for Australia, in particular, and many parts of the developed world in general. In short, the low scenario, at least to 2012 or thereabouts, does not have a low probability of outcome.

The high scenario assumes the most optimistic outcomes for the world political economy.

Australian energy trade, 2004-10

ABARE and NIEIR analysis and estimates of Australian energy trade trends are presented below. Over the period there continues to be an energy trade surplus with projected increases in net oil imports being more than offset by coal, natural gas and uranium export increases.

In 2004-05 the trade surplus, at a projected $7.4 billion (NIEIR/ABARE), will be about $2 billion higher than in 2003-04 due to higher thermal coal exports (tonnes, prices) and higher LNG exports.

Table 1        Major economic aggregates: financial year averages (annual per cent rate of change)

1998-99

1999-00

2000-01

2001-02

2002-03

2003-04

2004-05

2005-06

2006-07

2007-08

2008-09

International
G7 real GDP

2.3

3.4

2.4

0.2

1.9

3.1

3.3

2.6

2.0

2.5

2.2

Trade partners real GDP

1.4

5.6

3.7

1.6

3.6

4.9

5.0

4.2

3.7

4.4

4.3

G7 CPI

1.0

1.5

2.0

1.1

1.5

1.5

1.8

1.8

1.7

1.9

2.0

Trade partners CPI

6.0

2.1

2.7

3.1

2.9

2.8

2.9

3.0

3.0

3.3

3.3

GDP and components
Private consumption expenditure

4.8

4.1

2.9

3.3

3.8

5.6

4.1

2.8

2.8

2.6

3.5

Non-dwelling construction

13.2

-8.6

-18.4

12.3

32.0

12.0

5.8

5.4

2.1

-0.2

6.3

Equipment

1.0

11.1

6.1

6.1

16.7

6.0

9.6

5.4

5.3

5.5

5.3

Housing

7.6

14.4

-20.8

19.2

15.4

7.7

-6.3

-10.5

4.3

8.5

6.9

Public consumption expenditure

4.0

2.9

2.0

2.1

4.4

3.3

4.2

3.5

4.2

4.5

3.6

Public investment expenditure

3.9

7.6

-11.9

0.9

6.4

5.3

6.1

3.3

3.7

4.1

-0.9

Stocks and other (% points)

-1.3

0.6

-0.2

-0.4

0.1

-0.7

1.0

-0.1

-0.3

-0.2

0.4

Exports

2.0

9.6

7.3

-1.1

-0.5

0.9

5.1

6.6

4.8

4.3

2.3

Imports

4.8

12.9

-1.3

2.2

13.5

13.1

5.1

3.7

4.1

4.3

4.4

GDP

5.3

3.8

2.0

3.9

3.1

3.6

3.0

2.9

3.1

3.1

3.5

Farm GDP

13.7

9.9

-0.8

4.6

-25.2

26.8

-1.9

-2.3

4.9

5.4

0.0

Non-farm GDP

5.0

3.6

2.1

3.9

4.1

3.0

3.2

3.0

3.1

3.0

3.5

Dwelling sector
Commencements

-34.1

45.3

3.4

-0.8

-13.3

-7.9

16.3

-5.1

0.4

Labour market
Employment

2.0

2.1

2.1

1.2

2.5

1.8

1.9

1.8

1.8

1.7

2.4

Unemployment rate

7.4

6.6

6.4

6.8

6.2

5.8

5.6

5.6

5.6

5.7

5.7

Population

1.1

1.2

1.4

1.2

1.2

1.3

1.2

1.2

1.2

1.2

1.1

Wages and prices
Average weekly earnings

3.5

2.9

4.8

5.3

5.3

5.6

4.2

3.9

4.2

4.7

4.8

CPI

1.3

2.4

6.0

2.9

3.1

2.4

2.6

2.5

3.2

3.3

3.1

Real household disposable income

4.4

3.9

4.6

1.9

1.3

5.1

3.6

2.4

1.8

2.3

3.5

Finance
90 day bill rate (%)

4.9

5.6

5.8

4.6

4.8

5.3

5.4

5.1

5.0

5.1

5.5

10-year bond yields

5.4

6.5

5.8

5.9

5.3

5.7

5.8

5.6

5.8

5.9

6.1

$US/$A

0.63

0.63

0.54

0.52

0.58

0.71

0.73

0.74

0.72

0.70

0.71

External sector
Current account balance ($billion)

-33.6

-32.6

-18.0

-20.6

-40.3

-47.4

-45.7

-46.2

-48.2

-50.2

-55.5

Current account balance (% of
GDP)

-5.5

-5.1

-2.6

-2.8

-5.2

-5.7

-5.2

-5.0

-4.9

-4.8

-4.9

Table 2 The alternative scenarios: potential drivers

Low scenario

  • 1. Terrorist strike against oil supply infrastructure in the Middle East. Oil price spikes to US$70 and above. World growth falls to zero 2005-2007.
  • 2. Sharp devaluation of US dollar. Capital flight. US dollar devalues 40 per cent. Inflationary pressures in United States forces interest rates up to 8 per cent. Severe United States recession followed by a decade of slow growth.
  • 3. Slow growth in developed world results in protectionist measures against China/India. Environmental and economic problems, drying up of capital inflow from low Chinese growth after Beijing Olympics. China becomes isolated and military tensions in North Asia return to 1960 levels.
  • 4. The rise in world interest rates and slower world growth results in Australia’s current account deficit rising to 8 per cent of GDP. Australian interest rates are raised to reduce domestic demand. Consumption expenditure falls 5 per cent over two years. Capital flight from Australia devalues currency by 40 percent in trade weighted terms. Inflation of prices critical in demand expansion measures for some time. Governments are slow to adopt expansionary fiscal policies.

High scenario

  • 1. Iraq stabilises and political solutions reached in Middle East between Jews and Israelis.
  • 2. Terrorism reduced to minimum levels. Oil price returns to US$15 to US$25 range.
  • 3. Euro Asia adopts expansionary monetary policies. Current high savings ratios allows the borrow and spend dynamic to drive above average European growth rates for 10 to 15 years. European growth takes pressure off United States balance of payments. Reformist United States government from 2008 raises taxes and stabilises the fiscal situation. China continues to open up and changes from a commercial economy to a market economy.
  • 4. Political transition to a basic democratic framework. World trade expands at 6 to 9 percent a year resulting in a rapid convergence of living standards between India/China and the developed economies.

Table 3        Australian energy trade trends

(A$ billion nominal)

Commodity

2004-05

2010

Coal (thermal)1

6.3

7.5

Natural gas (LNG)2

3.5

5.1

Uranium3

0.5

0.6

Oil (crude and products)4

-2.9

-5.0

Total

7.4

8.2

Notes:

  1. 1.2004 average price = $50/t.
  2. 2004 exports = 8 Mt; 2010 exports = 20 Mt.
  3. Contract prices (A$/lb U3O8) rising by 20 per cent, 2003-10.
  4. 2004; 80 per cent net self sufficiency at A$60/b.
    2010; 65 per cent net self sufficiency at A$50/b.

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