Updating the Australian economic story

09 Mar 2017

Tags

  • Mark Thirlwell
  • Australian Economy
  • International Investment
  • International Trade

The past month has seen several substantial data releases, including details on the Q4:2016 national accounts and balance of payments. This set of numbers provides a nice opportunity to assess the state of the current consensus story about the Australian economy - hence this (rather long) blog post.

Before turning to the data, however, it’s probably useful to begin with a quick recap of the highlights of some past and current stories about Australia’s economic position. The old story – now fast receding into history – was of course the tale of the commodity boom. It was the story of an extraordinary surge in the price of key Australian resource exports, inspired in large part by demand from a rapidly industrialising and urbanising China. That boom drove up the terms of trade and delivered a major boost to our national income, and also encouraged a large increase in investment in the resources sector (including a major surge in foreign direct investment or FDI) that then helped to accelerate real economic growth. All of which also helped trigger a sustained appreciation of both the nominal and real exchange rates as well as contributing to a marked re-orientation in both the composition (towards resources) and direction (towards China) of our export profile.

Australia: Exports to China and Resource exports

Once the commodity boom had peaked, resource prices had started to fall, and mining investment had begun to slow, the search was on for a new narrative. Inevitably, that new story was mostly about how and whether Australia’s economy would be able to successfully adapt to the changed circumstances: would other sectors be able to replace mining investment as a source of growth, or would the economy fall off a ‘mining investment cliff’; how would the economy cope with declining commodity prices and the consequent transition from positive to negative terms of trade and income effects; and what would be the implications for our exports and exporters of changing patterns of Chinese (and global) demand alongside new exchange rate configurations?

Gross private fixed capital formation: Mining and Other sectors

Over the past few years, some of the details of that new story have gradually been filled in. Real economic growth has been sustained by an evolving mix of housing investment, consumer spending and larger export volumes, where the last is the product of all that earlier resource investment. As expected, income growth has fallen in line with the decline in export prices, a development reflected in budgetary pressures, low wage growth and subdued inflation. A lower and more competitive dollar (as well as impressive growth in regional demand from an expanding Asian middle class) has powered strong growth in exports of services in general and the Visitor Economy in particular. And the fall in mining investment was mirrored by a decline in FDI inflows. Real economic growth has slowed following the global financial crisis in line with worldwide trends, but despite the scale of the nominal (commodity price) and real (mining investment) shocks hitting the economy, Australia has nevertheless managed to avoid slipping into recession. It has also comfortably outgrown its peer group of other advanced economies over the post-crisis period.

Australia: Real GDP growth and Real GDP 2009-2015

This new narrative has also generated its own range of sub-plots. These have included (the return of) concerns about the consequences of rising household debt and rising house prices, the (related) ability of households to sustain consumption growth in the face of low wage growth, the prospects for a much anticipated but repeatedly delayed recovery in non-mining business investment, the implications of China’s economic transition for our trade profile, and the net outcome of the ‘race’ between falling export prices and rising export volumes. The most recent twists to the central plot line had been a bounce in commodity prices towards the end of last year and an unexpected fall in Q3 GDP growth which seemingly threatened to undermine Australia’s cherished run of a quarter-century-and-counting of economic growth without a technical recession[1].

In that context, the headline news delivered by the Q4:2016 GDP number was that real GDP growth was firmly back into positive territory (up 1.1 per cent over the previous quarter after falling by 0.5 per cent in Q3, and up 2.4 per cent in annual terms), a result which kept that precious recession-free story intact.

Australia: Real GDP growth

Quarterly growth was mainly driven by a combination of household consumption and public demand along with modest contributions from business investment and net exports. In annual terms, growth was also boosted by consumption as well as public demand and net exports, while in this case total business investment acted as a significant drag to overall activity.

Contribution to quarterly growth, 2016: Q3-2016:Q4 and Contribution to annual growth, 2015:Q4-2016:Q4

Overall, then, the final quarter’s results from 2016 were broadly consistent with the current consensus story about Australia’s economic performance: household spending, residential construction and net exports all supported growth by enough to offset the ongoing drag from declining mining investment.

Real export growth, for example, is now an important driver of the overall growth picture. In particular, already strong increases in volumes of exports of iron ore are now being supplemented by rising export volumes of LNG.

Australia: Real exports of goods and services and Australia: Real exports of selected resources

The fourth quarter also saw GDP growth receive some additional support from public sector investment spending, likely reflecting infrastructure spend at the state level. And as already noted, while total business investment continued to be a drag on overall growth in annual terms, it actually made a modest positive contribution to the quarterly outcome, reflecting some growth in the non-mining investment component.

A closer look at the investment numbers suggests that it’s at least possible that a couple of modifications to the standard narrative may now be in train. For example, there are at least some signs that the rise in residential investment may be at or close to its peak (although at the same time, the pipeline for future work still looks quite healthy). Likewise, the big decline in mining investment may also be drawing to a close: the RBA, for example, judges that we are now about 90 per cent through the downward adjustment in capital spending for the sector.

Australia: Business investment, Dwelling investment, Mining capex and Non-mining capex

The Q4 data also confirmed that household consumption spending has continued to support overall growth, once again in line with the overarching story. But here too there are some twists appearing in the plot line. In particular, while the overall economic adjustment process has been relatively successful in bringing the headline unemployment rate down to below six per cent and then keeping it there, measures of underemployment suggest that there’s still a fair degree of slack in the labour market. At the same time, wage growth has remained very subdued, with the wage price index growing at just 1.9 per cent in the December quarter – leaving wage growth running at its lowest rate since the start of the series.

Australia: Labour market slack and Wage price index

The silver lining to this weak wage profile is that it has been supportive of Australia’s relative international competitiveness, facilitating the real exchange rate adjustment that has helped deliver an increase in non-resource (especially services) exports. But it also means that households are having to sustain consumption growth by cutting back on their savings. In line with that, the Q4 reading showed the household savings rate continuing its recent downward trend, sliding to just over five per cent of net disposable income. Combined with the high and rising level of debt on household balance sheets, this suggests the possibility of some looming constraints on future consumption rates in the absence of any recovery in wage growth.

Australia: Household consumption, Household savings ratio, Household debt and Household debt service ratios

Still, there is some hope for stronger wage growth now appearing on the nominal side of the GDP story. Rising commodity prices since the end of last year have given a significant boost to overall export prices and pushed up the terms of trade. The latter rose by nine per cent in the December quarter and are now more than 17 per cent higher than they were at the start of last year.

Monthly commodity prices and Australia

That boost to the terms of trade fed into a sharp increase in nominal GDP growth in Q4, with nominal output jumping by three per cent in quarterly terms and by more than six per cent over the previous year. Normally, robust nominal GDP growth is associated with healthy wage growth, so December’s increase offers some scope for optimism on that front, albeit tempered by the consideration that any boost may prove temporary, given that most analysts currently expect the recent increase in commodity prices to be largely unwound by next year.

Australia: Nominal GDP growth

Meanwhile, the combination of higher commodity prices and strong resource export volume growth is already having a dramatic impact on Australia’s trade balance and current account position. The Q4:2016 balance of payments numbers showed the trade balance for goods and services swing into surplus for the first time since the opening quarter of 2014, a shift which in turn saw the current account deficit shrink from a shortfall of more than $10 billion in the third quarter of 2016 to a deficit of less than $4 billion by the fourth quarter. Expressed as a share of GDP, the current account deficit has now fallen to less than one per cent, its lowest level in decades.

Australia: Current account balance and Current account ratio

Australia has now run three consecutive monthly trade surpluses, with large surpluses on the goods trade balance more than offsetting a narrowing deficit on trade in services. Behind those numbers are a combination of sustained growth in exports of services and a recent surge in the value of goods exports, with the latter a product of the rise in resource prices described above.

Australia: Monthly trade balance to January 2017 and Export growth to January 2017

One further element of the balance of payments data worth noting before we wrap this up is that the numbers show a significant rebound in FDI inflows to Australia in 2016. On a directional basis, FDI inflows surged to $64.8 billion – the highest dollar inflow recorded this century. While we have to wait until May for a detailed country and sectoral breakdown, the headline number and the fact that Australia was again a top ten destination for FDI last year do seem to suggest that foreign direct investors are more than comfortable with the unfolding Australian economic story.

Flows of FDI into Australia, 2000-2017 and Top ten host economies for FDI inflows, 2016E

Taken together, then, this last batch of data suggests that the story about Australia’s ongoing economic adjustment continued to track reasonably well through the end of last year, albeit with the emergence of several interesting new plot twists around the central narrative.

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[1]  A ‘technical recession’ is defined (somewhat arbitrarily) as two consecutive quarters of negative real GDP growth.