Australia is well into recovery mode. But there are mixed blessings within different parts of the economy. Frank Gelber explains.
In the GFC-induced downturn, it was precautionary saving – by households and by businesses – that caused the weakening of growth. Afraid that they had borrowed too much, and afraid of unemployment, households cut spending. Companies, anticipating recession and subject to a credit squeeze with higher interest rate margins, went into cost-saving and cash-preservation mode. But that was offset by the continued strength of construction as we finished off projects begun before the GFC hit and by strong government stimulus. Domestic demand growth fell below 1 per cent in 2008/09 with GDP growth just over 1 per cent. We had a short and shallow downturn, not the widely feared recession.
It’s not just that we’re lucky. Australia didn’t suffer the same problems that caused financial crisis and recession in much of the developed Western world. Accordingly, there was no financial crisis in Australia – just a credit squeeze. And we won’t experience the long and difficult recovery in store for many other developed countries. For Australia, it’s back to business as usual.
Already the economy is well into recovery. Employment has rebounded, boosting household income. Households are cautiously letting go of the purse strings. Housing was boosted by low interest rates. We’ve seen the beginning of a recovery in profitability as demand recovers, but business investment remains subdued.
The economy paused for breath through the middle of the year as early and quite aggressive rises in interest rates hit households. Housing and retail sales appeared to run out of steam. But employment continued to grow strongly.
‘The recovery is not uniform across sectors. There will be winners and losers.’
Mind you, there will be more rises in interest rates before this is over. And that will eventually damage parts of the economy. But, before that, we expect a resumption of growth, with strong employment driving rising household income and expenditure. And the housing upswing has further to go.
The recovery is not uniform. Different parts of the economy will experience mixed blessings associated with the different drivers of growth.
A primary driver of growth will come from the minerals sector as it struggles to supply rapidly expanding demand from China. Strong profitability will underpin the next round of minerals investments and that’s what will drive economic growth, both in the regions and sectors that service that investment. Mind you, it’s growth in investment, not a high level of investment, which drives growth in the economy. And we’re already set up to service the current high level of net investment. So stimulus to the economy won’t be as great as during the first phase of investment last decade. Nevertheless, strong investment through the middle of the decade is already locked in.
A second driver will be the high dollar, which, in effect, is part of the transmission mechanism for a major shift of labour and capital to the minerals sector. Strong minerals prices and incomes, the high interest rate differential, and the strength of the economy attract the inflows of funds that are underpinning the strength of the Australian dollar.
And that’s the downside for the economy. It’s not parity that’s the big deal. That’s just a milestone. As far as I’m concerned, anything over US80c is a disaster for the competitiveness of domestically produced tradeables – both exports and import-competing goods and services. Over US90c is a catastrophe. And parity – we’ll lose another tranche of the domestic tradeables sector in this episode.
Mind you, there are winners and losers from a high dollar. The losers include agricultural incomes, tradeables manufacturing and tradeable services in the tourism industry, education and business services sectors. The winners include importers, including overseas travellers, retailers, consumers buying cheap imports and importers of capital equipment.
A third driver is interest rates. As the recovery proceeds, we’ll soon run into labour constraints, and then capacity constraints. Already, we’ve run through the RBA’s warning light of 3 per cent employment growth. The real problem will come as demand-inflationary pressure takes earnings inflation above 4.5 per cent. Interest rate rises have a long way to go. Three years from now we expect cash rates to be around 7 per cent and housing interest rates above 9 per cent. That’ll choke off the housing market and have an impact on household disposable incomes in the variable rate mortgage belt.
A fourth driver is government expenditure – strong now, but set to be cut sharply as the logic of “fiscal responsibility” takes over the budget processes of governments around Australia. My fear is that the medium-term impact will be on infrastructure spending and capacity. Meanwhile, the short-term question is whether private investment will come through quickly enough to offset the decline in public spending.
In this environment, we have seen, and will continue to see, mixed outcomes for different industry sectors around Australia.
The minerals sector is booming, with prices at levels allowing a 40 per cent profit margin. Exports are picking up at last as the investment boom finally adds to production capacity, as infrastructure allows its shipment and as the agricultural sector recovers from drought.
Importers of goods, services and capital equipment are doing extremely well as the rising dollar reduces their costs and takes pressure off their margins, and as import penetration rises at the expense of local import-competing industries.
The consumer recovery, albeit modest, plus the high dollar are boosting retailers. Even though growth is relatively subdued, retail margins remain high, underpinning profitability.
Australian banks, despite their bearishness, came through the GFC relatively unscathed and are now reversing their over-provisioning for bad debts. You’d think they’d be a little embarrassed at how well they are doing while many of their customers are still doing it tough. And they remain aggressive about perceived risk. We’ve effectively given them a franchise, and that should entail responsibility to households and industry. The banks can’t just be money-making machines.
The construction sector, having done really well out of hasty government construction projects, is now entering a tougher phase until growth comes through.
Businesses remain in cost containment /cash preservation mode, affecting the business services sectors.
And, of course, the dollar is playing havoc with the competitiveness of domestically produced tradeables – apart from minerals – both export and import-competing. That’s hitting the manufacturing, tourism, education and some services sectors, and affecting prices for agricultural produce.
Overall, we can’t expect growth to continue at the same rate as it did through the past decade.
Firstly, continuation of the investment boom – now that investment has risen to levels at which we are adding significantly to net capital stock – means lower growth in investment and a lower contribution to growth in the economy. We’ve already seen the growth required to service a high level of investment. The alternative, an end of the boom, would mean a fall in investment and a negative shock to growth. But, with this next round of projects locked in, sustained activity with moderate growth is ensured through the middle of the decade.
Secondly, capacity and labour constraints will inhibit our ability to grow. The downturn began at an unemployment rate of under 6 per cent. Even if, as we expect, employment growth were to slow, a year or two from now we’ll be running into tight labour markets, wage pressure and demand inflationary pressure.
The question is, where will growth take place? With the resources boom continuing to require a switch of resources to enable it to take place, the high dollar and the impact on the competitiveness of domestic tradeables is operating to facilitate the process. Hence we can expect competition for labour to continue to take resources from manufacturing, from agriculture, from tourism, from education and business services to service the growth of minerals.
The outlook is for strong growth over the next five years. But, while solid in aggregate, the recovery is not uniform across sectors. There will be winners and losers. And the boom won’t last forever. In all the kerfuffle about policy and the argument over income shares, we should be careful to prepare for the day when the minerals boom ends.
Dr Frank Gelber is director and chief economist of BIS Shrapnel.
