RESEARCH PAPER SERIES, 2016–17              9 May 2017

Pre-Budget snapshot of the Australian Economy: A Quick Guide

Nitin Gupta, Phillip Hawkins and Helen Portillo-Castro

Economics Section

To provide some context to the 2017–18 Budget, this article provides a brief overview of the domestic and international economic conditions, and the potential risks to the economy and budget forecasts.

Part I: the Australian economy—recent developments

While the Reserve Bank of Australia (RBA) cut the overnight cash rate twice in 2016 (in May and August), it has left it unchanged in its subsequent Statements on Monetary Policy.[1] The current rate of 1.5 per cent is the lowest rate since the RBA gained independent control of monetary policy in the early 1990s, but still one of the highest in the advanced world.

Overall macroeconomic situation[2]

The May 2017 Statement on Monetary Policy noted that the Australian economy grew by 2.5 per cent over 2016, which is a bit below central estimates of potential growth. However, growth over 2017 is expected to pick up gradually as a result of low interest rates and ongoing recovery in the global economy.

The May Statement also confirmed a transition away from a mining-based economy, with mining investment declining by 24 per cent over 2016. This was the only economic indicator that showed any decline. Dwelling investment and exports, on the other hand, grew by 5.6 per cent and 8.9 per cent, respectively. Consumption, business investment and public demand also grew and supported overall growth.[3]

Indicators of the state of the labour market remain mixed. According to the Statement, the unemployment rate and employment growth have both increased over recent months, with the latter expected to continue growing in the future. With regard to inflation, domestic cost pressures remain subdued. Labour costs, retail prices, and rent inflation continue to remain low, but this has been somewhat offset by increases in fuel, and utility prices, and by the rising costs of new dwelling construction.[4]

Exchange rates and capital flows

Since the start of 2017, the Australian dollar has appreciated around 3 per cent against the greenback and around 2 per cent against the Renminbi. These levels are much more favourable than the peaks attained in 2011–12, and have helped in the process of rebalancing the economy away from mining and towards other tradeable sectors such as manufacturing, services (including tourism and higher education) and agriculture. The appreciating currency also puts downward pressure on prices. However, it is not possible to conclude whether an appreciating exchange rate represents an overvalued dollar, even though RBA Governor Philip Lowe noted in his 7 February statement that an appreciating exchange rate could complicate the abovementioned adjustments.[5]

Debt and sovereign credit rating

Australia’s sovereign credit rating has been an issue of concern ever since Standard & Poor’s (S&P) downgraded its long-term outlook for Australia’s coveted triple-A sovereign credit rating in July 2016. The downgrading from ‘stable’ to ‘negative’ was due to ‘growing fiscal vulnerabilities’.[6] While the release of the Mid-Year Economic and Fiscal Outlook (MYEFO) in December 2016 led to Australia maintaining its triple-A rating, S&P still maintained a negative rating watch—which implies a one-in-three chance that Australia’s rating could be downgraded in the next two years.[7]

However, as Table 1 from the International Monetary Fund (IMF) below shows, Australia’s current and projected fiscal debt compares much more favourably with debt in other advanced economies.[8] This fact should be considered when making overall assessments of the seriousness of Australia’s overall debt situation.  

Table 1: Advanced economies: government debt, 2016 and 2021 (per cent of GDP)

Country

Gross debt

Net debt

2016

2021 (projected)

2016

2021 (projected)

Australia

40.9

39.0

19.7

18.5

Canada

92.1

82.2

26.9

17.2

France

97.1

93.8

89.2

85.8

Germany

68.2

56.7

45.4

36.8

Japan

250.4

253.9

127.9

131.5

United Kingdom

88.8

82.1

80.3

73.6

United States

108.4

108.3

882.3

84.4

Source: IMF, Fiscal monitor: debt—use it wisely, IMF, Washington, 5 October 2016, pp. 69–70.

Housing and overall indebtedness

The RBA has been monitoring aggregate trends in housing prices and household debt as they relate to the resilience of the economy. According to RBA Governor Lowe, in his speech of 4 May 2017, higher levels of household debt could leave the Australian economy more vulnerable if in the event of a shock to income or house prices, households cut their expenditure to try to get their balance sheets back in better shape. Household debt to income ratios are currently at record highs: these trends are depicted in Figure 1 below.[9]

Figure 1: Housing prices and household debt, ratio to household income, 1992–2016

Source: P Lowe (Governor, RBA), Household debt, housing prices and resilience: speech to the Economic Society of Australia (Queensland) business lunch, Brisbane, media release, 4 May 2017.

The RBA considers the factors influencing these parallel trends are unlikely to remain constant. For example, constraints on the supply side (including zoning issues and inadequate transport) are already being addressed in some major cities. While new housing developments and infrastructure investments are expected to ease pressure in the housing market, low interest rates should not be presumed to continue indefinitely. The high ratio of household debt is an ongoing concern in relation to consumption, particularly while income growth remains low.[10]

Part II: the international context

In summary

The global context for the Budget is best described as uncertain. While the global macro-economic situation appears to be improving, persistent geopolitical risks and policy volatility create uncertainties that the Budget must contend with. The Budget makes assumptions about how global economic and political trends will affect key Australian macro-economic variables, including those that directly impact upon the Budget. In the current environment, weakened economic prospects in China and continuing policy uncertainty in the United States (US), Europe and the United Kingdom (UK) imply that projections relating to the overall Budget performance should be treated with caution.

Global outlook

In its April 2017 World Economic Outlook, the IMF forecast a modest improvement in global economic growth citing increased confidence in the US, strong growth in large emerging markets and an improvement in global trade.[11] World economic growth is expected to improve from 3.1 per cent in 2017 to 3.7 per cent in 2019 (see Table 2).

However, the IMF and Organisation for Economic Co-operation and Development (OECD) have both recently warned that this modest economic recovery remains vulnerable. Potential risks identified by the IMF and OECD include challenges associated with economic transition in China, slow growth in the Eurozone (and uncertainty around Brexit effects), a potential global trend towards more protectionist economic policy, increased exchange rate volatility caused by divergences in interest rates between major economies, and rapid house price increases in major advanced economies.[12]

Table 2: International growth forecasts IMF (per cent)

2016

2017

2018

2019

2020

Australia

2.5

3.1

3.0

2.9

2.8

United States

1.6

2.3

2.5

2.1

1.8

China

6.7

6.6

6.2

6.0

5.9

Japan

1.0

1.2

0.6

0.8

0.2

United Kingdom

1.8

2.0

1.5

1.6

1.9

Euro zone

1.7

1.7

1.6

1.6

1.5

Advanced economiesa

1.7

2.0

2.0

1.9

1.7

World

3.1

3.5

3.6

3.7

3.7

a) weighted average of advanced economies growth rates

Source: IMF, World Economic Outlook Database April 2017

Economic transition in China

China is Australia’s largest trading partner. It has also been the main market for Australia’s resource exports, which have underpinned growth over the last two decades. The demand for Australian resources has been driven by the boom in Chinese infrastructure investments in the last 15 or so years.

Growth in the Chinese economy is expected to slow over the next few years, albeit from a point of comparatively high growth rates (from 6.7 per cent in 2016 to 6.2 per cent in 2018).[13] This moderation has been widely anticipated as the Chinese economy transitions from an economy driven by significant investment in infrastructure to a more consumer and service-based economy.[14] 

In the future, Australia’s economic performance will be closely tied to its ability to continue to supply China’s increasing demand for goods and services (notably, agricultural goods and educational services).

It is also important to note that the IMF has cautioned about considerable vulnerabilities to economic growth in the Chinese economy: 

The IMF suggested China take measures to address the growing vulnerabilities associated with the rapid credit expansion. It also warned that protectionist measures adopted by advanced economies could lead to a broader tightening of financial conditions in China, possibly exacerbated by capital outflow pressure, which could have an adverse impact on the Chinese economy.[15]

Trade policy uncertainty

There is significant uncertainty about the future direction of trade policy globally. The OECD warns that a rollback of trade openness would be costly, with a significant share of jobs in many countries (including Australia) linked to global value chains. An increase in trade barriers between major global trading partners would have adverse impacts on global GDP.[16] 

The trade policy of the Trump administration is particularly uncertain; President Trump has withdrawn the US from the Trans-Pacific Partnership and has repeatedly called for a renegotiation of the North American Free Trade Agreement. His statements on China have also raised concerns about a possible tariff war with China, although he has moderated his previous statements about alleged Chinese currency manipulation.[17]

Brexit and policy uncertainty in the Eurozone

The impact of Britain’s exit from the European Union (EU) on its economic position in the long run will depend on the outcome of the exit negotiations between the UK and EU, but currently there is disagreement between the UK and the EU over how Brexit should be structured.[18]

At this stage it appears that a key challenge for the UK will be to renegotiate its trade agreements with its trading partners. During the G20 meeting concluded in China in early September last year, prime ministers May and Turnbull discussed a direct trade relationship between the UK and Australia, and officials from both countries are slated to discuss establishing a trade negotiating team.[19] 

The results of the recent French election are likely to reduce uncertainty about the future of the EU, but nevertheless, reform of the EU is still likely.[20] 

Interest rate and foreign exchange risks

The OECD argues that the recent modest economic recovery has been over-reliant on monetary policy and that this has created significant financial vulnerabilities. Many countries, including Australia, are seeing an increase in household indebtedness caused in part by low interest rates. Long-term interest rates have been rising globally in recent months (although they remain low by historical standards) and the OECD warns that these increases in interest rates could result in a ‘substantial and wide-spread’ devaluation of financial assets whose value in recent years has been supported by low interest rates.[21]

Further, recent interest rate rises have been associated with significant changes in global exchange rates; the US dollar in particular, has appreciated significantly against other major currencies. The US is likely to increase the interest rate twice more in 2017.[22] An important consideration stemming from the possible rise in US interest rates is that an increase could trigger a global capital flight towards the US which could further appreciate the US currency relative to the currencies of emerging economies and trading partners. The net impact on the Australian dollar of a rising US interest rate is uncertain.

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[1].               Reserve Bank of Australia (RBA), Statement on monetary policy: November 2016, RBA, 3 November 2016; RBA, Statement on monetary policy: February 2017, RBA, 10 February 2017.

[2].               This section is adapted from the Reserve Bank’s Statement on monetary policy: May 2017, RBA, 4 May 2017.

[3].               Ibid.

[4].               Ibid.

[5].               RBA, Statement by Phil Lowe, Governor: monetary policy decision, no. 2017–02, media release, 7 February 2017.

[6].               F Chung, ‘S&P puts Australia on credit watch’, news.com.au, 7 July 2016.

[7].               D Scutt, ‘Australia's AAA credit rating is now under even more pressure, says S&P’, Business Insider Australia (online), 19 December 2016.

[8].               International Monetary Fund (IMF), Fiscal monitor: debt—use it wisely, IMF, Washington, 5 October 2016, pp. 69–70.

[9].               P Lowe (Governor, RBA), Household debt, housing prices and resilience: speech to the Economic Society of Australia (Queensland) business lunch, Brisbane, media release, 4 May 2017.

[10]               Ibid.

[11].              L Thomas Jr, ‘IMF raises 2017 outlook for global economic growth’, The New York Times (online), 18 April 2017.

[12]               IMF, World economic outlook, April 2017: gaining momentum?, IMF, Washington, April 2017; OECD, Interim global economic outlook, IMF, March 2017

[13].               IMF, World economic outlook, April 2017: gaining momentum?, IMF, Washington, April 2017, pp. 46–47.

[14].               IMF, People’s Republic of China—selected issues, IMF, 12 August 2016.

[15].               State Council of the People’s Republic of China (Chinese Government), ‘IMF upgrades China’s growth forecast in 2017 and 2018’, Chinese Government Top News English-language website, 19 April 2017.

[16].               OECD, Interim global economic outlook, IMF, March 2017.

[17].               M Schultz, ‘Trump backtracks on calling China “currency manipulators”’, New York Post (online), 12 April 2017.

[18].               R Revesz, ‘Theresa May’s disastrous Brexit meeting with European Commission President Jean-Claude Juncker laid bare’, The Independent (online), 1 May 2017.

[19].               T Ross and S Swinford, ‘G20: Theresa May in talks over a free trade deal with Australia after Brexit’, The Telegraph (online, UK), 4 September 2016.

[20].               F Guarascio and A Macdonald, ‘Juncker launches post-Brexit EU reform proposals’, Reuters, 1 March 2017.

[21].               OECD, Interim global economic outlook, op. cit., p. 5.

[22].               E Holodny, ‘US Fed holds, says growth slowdown is “transitory”’, Business Insider Australia (online), 4 May 2017.