Thursday, July 23, 2009

Australia's economic outlook - cautions and constraints

Just six months ago, Access Economics' Chris Richardson was all gloom and doom about the Australian economy to the point that his comments triggered a number of posts here and on my personal blog because I just couldn't see it in the numbers. I was far more positive. Now Chris is cautiously optimistic.

Chris' cautious optimism comes at a time of increasing optimism in general reporting in Australia and internationally. Just as the previous gloom and doom led me to check numbers and come to an opposite conclusion, now I am wondering about some of the current reporting. To what degree has the optimism/pessimism effect gone into reverse?

To assess this, I thought that the best way was to look at the reasons why I was more optimistic before, along with my expectations about future developments. I seem to have been pretty right on the first, what about the second?

To begin with, I saw the remarkable change in Australia's trade performance - the switch from deficit to surplus on the current account at just the time we needed it - as central. This, together with an unexpected and in fact unwarranted fall in the value of the Australian dollar, cushioned Australia to some degree and gave the Australian Government far more room to move.

Balance of Trade May 09 Since then, the value of the Australian dollar has bounced back, while the balance on the current account has turned slightly negative. You can see the latter clearly in the attached chart from the Australian Bureau of Statistics. Remarkable improvement, followed by partial retreat.

I am not too worried by this, I had expected it, but again we need to watch because the current trend means that the balance of trade on good and services has turned from a positive to neutral, potentially negative.

So far as the exchange rate is concerned, I won't comment in this post beyond noting that whereas I had seen the balance of probabilities favouring an appreciation, after the last bounce I think that they are now neutral tending to negative. From my immediate viewpoint, that's not a bad thing.

In terms of my previous analysis, Australia's unexpectedly strong trade position was reinforced by other variables - a budget surplus, no net Australian Government debt - that provided the capacity for the country to manage through the downturn until the global economy recovered.

At the time I did not expect the global stimulus packages to have much immediate impact beyond band-aid until increased Government capital spending kicked in. I also expected capital spend to be far more lagged in Australia and elsewhere than projected by Government because of the nature of intuitional constraints. Overall, I think that the band-aid has been somewhat greater than I expected, the capital spend lags pretty much as expected.

My key concern about Australia and elsewhere lay in rapid increase in liquidity and Government debt. I thought that this was likely to choke growth to some degree as policies went into reverse. This remains my view.

debt-hhold If you look at the chart on the right from Stubborn Mule, you can see how Government gross debt came down and is still at very low levels by global standards. Australia still doesn't have a real problem. The colour bars, by the way, mark periods of Labor Government.

The problem lies in the steady rise in household debt, a lot of which is linked to house purchases.

I have been generally supportive of the Rudd Government's stimulus packages with the notable exception of the First Home Buyers grant for existing houses. This has triggered something of a price boom at the lower price end of the housing marketplace, holding borrowing levels up.

The difficulty with Australia's continuing high levels of household debt lies in the way that interest rate rises create downward economic pressures. Australian interest rates are going to rise over the next two years, and as they do there will be downward pressure on spending in other areas.

I am out of time. I will continue this post a little later.

I said that I expected Australian interest rates to rise over the next two years. At one level, that statement is almost a truism given how low they are now. However, there are still inflationary pressures in the economy.

When I looked at the Australian Producer Price Indexes for June, the thing that stood was the difference between the indices for domestic and imported products. It's quite noticeable that all the major price falls month on month are on the imported side. The year on year position is different, with the rise in price for imported final goods showing a dramatic increase despite recent monthly falls.

My gut judgement, and its not fully supported by the figures, is that price pressures are still there in the more sheltered non or part-import competing sector. On the import side, and excluding exchange rate considerations for the moment, recent price declines are likely to stabilise as the global economy stabilises.

If we now look at the latest CPI figures, the low year on year CPI appears to have been strongly influenced by falls in transportation and insurance and financial services costs. The big increases, all above the Reserve Bank's target inflation band, were education, health, housing, food and alcohol and tobaccos. What can we say about this?

Well, transportation is strongly influenced by fuel costs, so if fuel prices rise as the global economy starts to rise again, we can expect this item to rise. Insurance and financial services costs are strongly influenced by interest rates, and will rise with interest rates.

On the other side of the ledger, the majority of high rise items are in non-import competing sectors and will rise as the Australian economy starts to expand. Rents are already rising. In addition, there are built-in upward factors in education and health. So at least potential CPI and health pressures are still there.

I stand to be corrected on this very simple maths, but it looks to me as though potential inflationary pressures are still present. Should they emerge, then the Reserve Bank will have to think about interest rate rate rise. 

Then we have to factor in Government borrowings. The need to borrow in Australia and overseas to fund stimulus packages will of itself place some pressure on interest rates. So we have a whole set of reasons to expect interest rate rises, with consequent downward pressures on demand.

I now want to bring in a another variable, China.

I have previously expressed concerns about the hope placed on China. Part of this is due to to the relative size of the Chinese economy. It is simply not big enough in absolute terms to have the type of global pull-through effect expected in the absence of growth elsewhere. Part is due to what I see as the vulnerabilities in the Chinese economy itself. Here I am influenced by the writing of Michael Pettis.

I lack the direct knowledge to properly critique Michael's work. But at the very least, it suggests grounds for caution.

This has become quite a long post, so to summarise.

Just as I thought the early gloom about the Australian economy was misplaced, now I am cautious about some of the optimism. Australia is still well placed, that hasn't changed, but I do think that there are some risks and downsides that we now need to factor into our thinking.         

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