9
May 2017
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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.
[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.
All online articles accessed May 2017
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