Thunder Down Under: Australia Braces for a Storm
Despite the challenges of the past few years, economic growth in Australia has been remarkably immune to the economic weakness that has characterized the recoveries across the rest of the developed world. In fact, Australia can claim the title of the strongest developed economy in the world over the past six years or so, as measured by GDP growth (Figure 1).
While part of Australia's economic success story has to do with a less-levered fiscal situation and resilient domestic demand, a major driver of growth for Australia has been strong raw material exports to fast-growing emerging market economies, particularly China. But as growth in China and elsewhere in the developing world begins to slow, we consider whether Australia can continue to show the resilience it has for the past several years.
We also weigh measures taken by the Reserve Bank of Australia (RBA) to gird the Aussie economy against fallout that may emerge from a further deterioration in the European debt crisis. Finally we look at drivers of growth in the domestic economy and try to put some perspective around the housing market in Australia. Slower global growth seems to be in the winds; this paper considers how the Australian economy has been holding up thus far and how it will continue to grow in the quarters and years ahead.
In the wake of the financial crisis in 2008 and ensuing global slowdown in 2009, the global economy bounced back in 2010 as global GDP increased 5.1 percent. But between the sovereign debt crisis in Europe, subpar growth in the United States, and diminished consensus expectations for emerging market performance, we think global growth in 2011 will be limited to 3.5 percent, followed by full year GDP growth of just 3.2 percent in 2012.1
Reserve Bank Keeping a Worried Eye on Europe
For the first time since the financial crisis in 2009, the Reserve Bank of Australia (RBA) has cut its key lending rate, the cash rate, at back-to-back meetings (Figure 2). The easing moves have brought borrowing costs down a half of a percentage point since early November. The official rate in Australia, now at 4.25 percent, is still the highest rate among the world's developed economies, but the recent easing recognizes vulnerability in Australia to the deterioration in the outlook for global growth, particularly the threat of a worsening situation in the Eurozone.
At face value, the situation in Europe may not seem to be all that critical to Australia. Just 4.1 percent of Australian exports are destined for European shores. The lion's share of Australian exports (60.5 percent as of 2010) is destined for other Asian economies, particularly China, which itself commands a 25.1 percent share of all Australian exports. However, Australian policymakers understand that Aussie exports of raw materials end up in manufactured goods made in China and elsewhere in Asia and are ultimately bound for markets in the rest of the world, particularly Europe. Cognizant of this contagion risk from Europe, the RBA acknowledged in the minutes of its December meeting that “[t]rade in Asia is now, however, seeing some effects of a significant slowing in economic activity in Europe.” The official statement underlined this risk, observing that “sovereign credit and banking problems in Europe…are likely to weigh on economic activity there over the period ahead.”
While the headline rate of inflation remains slightly elevated at 3.5 percent through the third quarter, the downtrend below 2.5 percent in the core inflation rate grants the RBA the scope necessary to pivot to a more supportive stance without fear of engendering runaway inflation. Also, a slowing in global growth is often accompanied by a more constrained rate of price growth
Domestic Economy Still Strong, but Slower Export Growth
So far, the Australian economy seems to be weathering the weaker global growth environment rather well. The economy expanded at a 3.9 percent annualized rate in the third quarter. Not only was the outturn better than consensus expectations, it marked the second fastest pace of expansion in Australia in three and a half years (Figure 4).
The largest contribution to growth came from a spike in business fixed investment spending which grew at an annualized 26.1 percent pace in the quarter. This gain in business spending was driven by a 24.4 percent (not annualized) jump in spending on non-dwelling construction, specifically new engineering construction, which reflects in part the boom in mining related investment.
Another strong component of growth in the third quarter was consumer spending, which grew at a 4.8 percent annualized rate. The strength here was somewhat of a surprise given the recent deterioration in Australian consumer sentiment. The Westpac-Melbourne Institute's Consumer Sentiment Index took a nose dive in July plunging 8.3 percent—the largest one-month drop since the height of the financial crisis in October 2008. The confidence measure fell again in August before turning positive in the final month of the quarter in September. Despite the sour sentiment, Aussie consumers still hit the stores helping propel consumer spending to the fastest rate of growth in more than year.
The strength in domestic demand sparked an increase in imports. Imports grew at an annualized pace of 18.2 percent in the third quarter. It was the fastest pace of import growth in two years, but it outpaced the growth of the country's exports resulting in a drag from net exports of 2.4 percentage points. Net exports have been weighing on headline growth in Australia now for seven consecutive quarters (Figure 5).
Headwinds for the Domestic Economy
We have already discussed the concern of the Australian central bank regarding further deterioration in Europe and how a sovereign default or worsening in the situation there might indirectly stymie Australian exports. In this section we consider threats to the domestic economy and whether or not the economy can continue to expand even as prospects for expansion are dimming in many other parts of the global economy.
An Australian Housing Bubble?
In the United States, the United Kingdom and parts of Europe, the fallout in the housing market in those economies is not only having an negative impact on construction employment, it also weighs on consumer spending and confidence. This negative wealth effect was far less of a concern in Australia. Existing home prices fell just 5.5 percent on a peak-to-trough basis between 2008 and 2009, a decline that pales in comparison to the magnitude of declines in the United States and Europe.2 The recovery in the Australian housing market has been exceptional as well. After the rather small decline during the global slowdown, established home prices went on to reach new highs. By the second quarter of 2010, home prices had increased to a level that was 14.4 percent above the previous high reached prior to the global slowdown. This run-up in home values has led to some market watchers to worry about a housing bubble in Australia. That said, Australian home prices have proved to be susceptible to gravity in the past year and a half or so. From the second quarter of 2010 through the third quarter of 2011, home values are off 3.3 percent.
The increase in Australian home prices has not necessarily been matched with runaway growth in residential construction activity. Home construction in just about any economy has a tendency to be cyclical in nature. A look at residential construction in Australia since the early 1990s demonstrates that boom and bust cycles are a reality for Aussie homebuilders as well (Figure 7).
What is remarkable about the homebuilding experience in Australia is the timing of the run-up in activity. Unlike many developed economies that were overbuilding in the middle part of the last decade only to come to a screeching halt when the crisis hit in 2008 and 2009, Australian homebuilding really did not take off until 2009. Even at the height of building in this cycle, the pace of homebuilding never exceeded the rate of building during the boom years of the mid 1990s. The other observation to make here is that residential construction has slowed down in the past few months and at its current pace of 4,758 dwellings per month is in line with its long run average between 2002 and 2008. Things have slowed down at the permit office as well, with building permits running very close to the slowest pace seen in the past decade. This is not to say that Australia is sure to avoid a housing bubble, but it is not as though residential construction activity is way out of control. Still, residential construction will not likely be as additive to GDP in coming years at it was during the building boom of 2009 and 2010.
Australian Employment Situation
During the credit crunch in 2008, Australian households temporarily went into hiding and household expenditures were a drag on GDP growth for the majority of the year. At that time, the Aussie government stepped in and picked up spending, which provided a welcome offset to the drag from weaker consumer spending (Figure 8). In subsequent quarters, confidence returned and Australian consumers began spending again. Indeed, household expenditures have been a boost to headline economic growth in Australia for ten straight quarters. If slower global growth does begin to materialize, the resulting slowdown in Australian exports would eventually begin to weigh on job growth and earnings in Australia and consumer spending could slow again. The Australian government is still running a modest budget deficit, so it is not clear how inclined the government would be to spend again in this cycle. More cautious spending by the Australian government was a modest drag on growth in the third quarter.
One harbinger of a slowdown in consumer spending would be a sign of weakening in the Aussie job market. While the unemployment rate has edged higher this year (Figure 9), the present rate of 5.3 percent remains among the lowest jobless rates of the world's developed economies. Australian employers reduced the number of fulltime employees on their payrolls by 39,900, marking the second largest monthly decline in full-time employment in the past year. An increase in part-time employment of 33,600 softened the blow somewhat to reveal an overall decline in employment of just 6,300. The overall job market has been going sideways for some time. Between March 2011 and November, the net change in total employment is an increase of just 1,800 jobs.
Summary & Conclusion
Australia's robust domestic economy has proven to be remarkably resilient, even in the most adverse circumstances. The credit crunch in the autumn of 2008 and the ensuing global slowdown plunged every developed economy but Australia into recession. Australia only experienced one quarter of economic contraction during the fourth quarter of 2008. Nearly three years later, in the first quarter of this year, the simultaneous hits of catastrophic domestic flooding and the knock on effects to exports resulting from the Japanese tsunami stymied economic growth, but again, just for a single quarter. In both instances, growth came back stronger in the subsequent quarter.
The biggest threat to the global economy and to Australia at present is the risk of further deterioration of the sovereign debt crisis in Europe. Even if world leaders come up with a solution to stave off a global financial crisis, it appears likely that global growth is poised to slow. Australia is heading into this storm on about as good a footing as any developed economy. Its unemployment rate remains low, even if job growth has been weak. Home prices have risen fast enough to stoke concerns of a bubble, but residential construction activity has come back down to earth. Government spending may not be the offset that it was in 2008, but the gradual arrival of slower global growth in this cycle will be less startling to Australian consumers than the financial crisis of 2008. Barring a complete collapse of the Eurozone or a major sovereign default, Australia is likely poised for a period of slower growth. But strength in domestic demand combined with accommodative monetary policy from the RBA should result in a soft landing scenario where Australia experiences slower growth, but avoids recession.