Country Report Australia
The Australian economy performed well in 2012 thanks to its strong trade links with China. The outlook for the coming year is quite positive, with growth again being narrowly driven by the mining business following the trend seen over the past decade. This increasing dependence on the natural resources sector and exports to China also constitutes the main risk for Australia. A downturn in China could significantly hurt the external sector. High commodity prices in combination with being seen as a ‘safe-haven’ is pushing up the currency, which erodes price competitiveness of non-commodity exports, as is plainly visible in a widening trade deficit despite the strong terms-of-trade position. It would be preferable to reduce the budget deficit faster in the current period of strong economic growth to prepare for more adverse economic situations. Positive developments are the on-going private sector deleveraging and a partial shift of banks’ funding mix towards deposits and away from foreign wholesale funding.
Australian economy: a two-speed economy
The Australian economy performed well in 2012 thanks to its strong trade links with China. Commodity exports as well as private investment in mining and liquefied natural gas projects were the major growth drivers, while domestic demand and other tradable sectors (e.g. tourism and manufacturing) were a drag on economic growth. Clearly, the high exchange rate is taking its toll on the Australian economy. The economic outlook for the coming year is stable (IMF expects growth to be around 3-3.5%), with growth again being narrowly driven by the mining business following the trend seen over the past decade (figure 1). The recent natural disasters, the floods in the Queensland region and the bush fires in Victoria, have not seriously hampered growth.
The economic fundamentals of Australian remain strong. Unemployment (around 5%) is still higher than before the global financial crisis, but close to its historical rate. Inflation is low and stable (around 2%) as a result of the declining tradable goods prices. Compared to the other developed countries, public finances are strong, with the gross public debt-to-GDP ratio being only 24%. The budget deficit is estimated to be 2.5% of GDP in 2012. The government strives towards a balanced budget within the near future, which means fiscal policy will remain contractionary going forward. For the current fiscal year (ending in June 2013) the deficit target will probably not be reached. In response to lower inflation and the weaker economic outlook, the Reserve Bank of Australia moved towards a more accommodative monetary policy stance by cutting its cash target rate to 3% (was 4.25% at the start of 2012).
Dependent on China’s demand for its commodities
Australia is becoming increasingly reliant on demand from the emerging markets, and in particular from China. The Asian countries became the most important trading partners, whereby the export share to China increased from 5% in 2000 to 27% in 2011. The recent big investments in the natural resources sector makes the economy even more centred around the mining sector and more dependent on commodity demand. As such, a hard landing in China, which is not our base-case scenario, could trigger a downturn in commodity prices and therefore lead to a negative external shock. Ultimately, banks’ balance sheets and the government’s fiscal position will be negatively affected. The IMF estimated that a 1% growth slowdown in emerging Asia could lower Australian GDP by about 1/3%.
An overvalued exchange rate
The Australian Dollar appreciated markedly over the last couple of years due to the increased demand for commodities (figure 2). Also portfolio reallocation towards Australian government debt that acts as a safe haven seems to be one of the reasons behind the strong currency. Whereas the currency is now acting as a buffer against economic overheating, it is also driving a wedge between mining and non-mining economic activity. Currency overvaluation affects the competitiveness of non-mining tradable sectors and so reallocates resources towards the mining sector. In other words, Australia is suffering from what is commonly known as the Dutch Disease.
For the current government, managing economic growth and preparing for a future after the mining boom will remain a challenge. The OECD expects the positive effects of the mining investments to fade in 2014, since commodity prices are decreasing while productions costs are on the rise. The introduction of a carbon tax and a tax on natural resource revenues are examples of measures used to make growth more sustainable. In order to cope with volatility in mining revenues, a build-up of sovereign buffers would be a welcome development. Moreover, the additional savings could help to stabilize the exchange rate. Note that the upcoming elections make the necessary policies more difficult to achieve.
The next federal election will be held on 14 September. Basically, the choice is between two coalitions. Currently in charge is the block formed by the Labour party and the Greens; the opposition is named ‘the Coalition’, which is formed by the Liberal Party and the National Party. In the polls, the Coalition is far ahead (receiving 57% of votes), but much can happen in the meantime. Before elections no big plans will be made and fiscal consolidation will fall behind schedule, especially as the Greens abandoned the power-sharing agreement with the Labour Party.
Even if ‘the Coalition’ is going to win the elections, not much will change in the near term. Their leader, Tony Abbott, stated that he will repeal the Minerals Resource Rent Tax and the Carbon Tax, although this will prove impossible as he cannot win a majority in the Senate. His election could lead to less regulation for the natural resources sector, and so increasing the competiveness of the Australian mining business. The possibility of a political deadlock, however, cannot be excluded. The political uncertainty introduced by the new elections, therefore, will not be of any help to introduce the necessary reforms to prepare Australia for the future.
Structural weaknesses of the Australian economy include its yawning current account deficit, the relatively high household indebtedness and the banks’ reliance on foreign funding. The deleveraging of the household sector continues, with private saving being constant around 10% of disposable income. Private sector credit growth slowed down considerably to a level comparable with private sector income growth, according to the Reserve Bank of Australia credit growth was around 4% y-o-y in 2012, down from 15% y-o-y in 2009. Notice that the level of private sector credit is still high in an international comparison (180% of GDP in 2012). The persistent current account deficits over the past years resulted in a large negative net international investment position (amounting to 58% of GDP in 2011). This causes a persistent deficit on the net income account, for which a large trade surplus is needed to compensate. The trade account became positive after the crisis, but recently started to deteriorate as the natural resources sector investments caused an increase in capital goods imports. Also the value of the exports declined recently, since commodity prices have fallen somewhat. What’s more, the challenges faced by the tourism sector due to the strong exchange rate are reflected in falling exports of services. Going forward, the added mining capacity increases export capacity and, therefore, could have a positive impact on the current account, though at the same time it aggravates the Dutch Disease problem.
The Australian banking sector is in general sound and able to withstand significant economic shocks according to stress tests performed by the Reserve Bank of Australia and the IMF. The banks though are exposed to some downside risks. The sector is highly concentrated with the four biggest banks together having a market share of about 80%. These banks have very similar business models, thereby increasing contagion risk in a crisis event. Residential mortgages represent the biggest part of the banks’ assets. House prices have fallen more than 8% between mid-2010 and mid-2012, but recently show signs of stabilization thanks to more accommodative monetary policy. The rate of non-performing housing loans is still very low, less than 1%, and more households are beginning to pay down mortgages ahead of schedule. Even if house prices were to decrease considerably again, credit risk for the banking sector is limited given their conservative mortgage lending practices. The average loan-to-value (LTV) ratio is 50% and the loan is covered by private mortgage insurance when the LTV is higher than 80% at origination. Moreover, the Australian Prudential Regulatory Authority sets relatively high standards for the amount of capital that banks have to hold for residential mortgages when compared to other countries.
The banks’ funding risks are lowered, since their reliance on foreign wholesale funding decreased markedly, 55% of banks’ funding requirements are now met by deposits (compared to 40% in 2008). Also the share of short-term debt has fallen considerably.