Note originally prepared as a briefing for ANZ CEO Mike Smith’s meeting with the Prime Minister and Treasurer on 23rd October 2008)

  • Australia’s economy was slowing going into the unfolding global recession, reflecting the (successful) efforts by the Reserve Bank to rein in what had been an unsustainable rate of growth in domestic spending (approaching 6% in real terms in 2007, nearly double the economy’s potential growth rate) in order to halt and then reverse a worrying acceleration in inflation.
  • From this starting point, Australia is exposed to the global recession which we believe is now under way, and the forces precipitating it, through three main channels:
    • commodity prices have fallen abruptly, and are likely to fall further, reflecting the slowdown in China and (arguably more importantly in this context) the recessions now under way in major industrialized economies). As a result, Australia’s terms of trade (the ratio of export to import prices) are likely to be only 6% stronger, on average, in 2008-09 rather than 16% as assumed in the Budget Papers, and to decline by around 7% in 2009-10. This means that growth in real gross disposable income (GDI) will actually be lower than growth in real GDP (by a margin of more than 1 pc point), reversing the contribution which rising terms of trade made to national disposable income over the preceding seven years;
    • because Australia is wholly reliant on the overseas borrowings of its banks to finance what is the world’s sixth largest current account deficit (unlike other countries with larger deficits), the increase in wholesale funding costs experienced by banks around the world has been transmitted to Australia even though Australian banks have little or none of the exposures which have led to such significant erosion of confidence in North American and European banks;
    • Australian business and household confidence has been significantly adversely affected by the torrent of bad news concerning the global economy, and by the losses which they have themselves directly and indirectly sustained through the fall in the Australian sharemarket over the past year, as well as by increases in interest rates and in food and fuel prices over the previous two years.
  • Against this, Australia has more scope than most other Western countries to deploy the conventional instruments of economic policy to counter these contractionary influences. In particular:
    • there is greater scope to cut Australian interest rates simply because they were higher to begin with than in most other countries (apart from New Zealand), and the Reserve Bank has already demonstrated its willingness to do so;
    • the Australian Government has greater scope to ease fiscal policy than governments of most other Western countries, because it is starting from a position where the budget is in surplus and with no net public debt, and (again) has already demonstrated its willingness to do so.
  • Economic forecasts should be interpreted with more than the usual degree of scepticism in the current environment. However, for what it’s worth:
    • we do not expect that Australia will experience recession, in the popular sense of consecutive quarters of negative economic growth (although many other Western economies will); rather, we expect that real GDP growth will average 1½% in 2008-09 (well below the Government’s Budget forecast of 2¾%), followed by 2% in 2009-10. Real GDP could well have contracted in the current quarter but for the probable impact of the measures announced last week. On a ‘through-the-year’ basis, we expect real GDP growth to slow from 2.7% in the June quarter to a trough of 1.1% in the March quarter 2009, followed by a gradual pick-up to 2.2% in the December quarter 2009;
    • we expect the unemployment rate to rise from 4.3% in September to around 5¼% by the June quarter 2009 and to peak at 6¼-6½% by the end of 2009. This is almost entirely the result of insufficient net new jobs being created to absorb new entrants to the labour force (from a high rate of immigration as well as those leaving formal education), rather than from significant net job-shedding. On the contrary, we expect that businesses will prefer where possible to ‘hoard’ labour, conscious that over the medium term demographic change will make labour relatively scarce. There could, however, be significant reductions in hours worked among casual or part-time employees and the self-employed.
    • inflation is likely to fall more quickly than previously expected, with the annual ‘core’ rate dropping from 4.7% over the year to the September quarter just ended to 3% by the December quarter of 2009 (as against the June quarter of 2010 in the Reserve Bank’s most recent forecast).
    • we do not expect significant, across-the-board, declines in residential property prices, despite the fact that Australian property prices are undoubtedly high (relative to incomes or rents) by historical standards and, superficially at least, by historical standards. Unlike the US or the UK, Australia does not have an underlying over-supply of housing; nor is effective supply being boosted by large numbers of dwellings on the market for sale at any price, by owners unable to service their mortgages or by mortgagees-in-possession anxious to recoup at least some of the value of their outstanding principal. If Australian home-buyers did not fall behind in their mortgage repayments on the same scale as American or (to a lesser extent) British home-buyers in the face of much higher mortgage rates than in America or Britain, it is hard to see why they should do so now that mortgage rate are declining sharply (provided that unemployment does not increase sharply).
  • These forecasts assume that further policy support for economic activity will be forthcoming:
    • we assume the official cash rate will decline from 6% to 4½% by the June quarter of next year; and
    • the Commonwealth government will implement further fiscal policy decisions to underpin economic growth, particularly as regards infrastructure investment, even if this results in a Budget deficit in 2009-10.

Saul Eslake (22nd October 2008)